5.4 Stock Options

ASC 718-10

25-11 Options or similar instruments on shares shall be classified as liabilities if either of the following conditions is met:

The underlying shares are classified as liabilities.
The entity can be required under any circumstances to settle the option or similar instrument by transferring cash or other assets. A cash settlement feature that can be exercised only upon the occurrence of a contingent event that is outside the grantee’s control (such as an initial public offering) would not meet this condition until it becomes probable that event will occur.

25-12 For example, a Securities and Exchange Commission (SEC) registrant may grant an option to a grantee that, upon exercise, would be settled by issuing a mandatorily redeemable share. Because the mandatorily redeemable share would be classified as a liability under Topic 480, the option also would be classified as a liability.

The sections below discuss guidance on the classification of stock options and similar instruments. See Section 5.3 for guidance on determining the classification of puttable and callable stock awards.

5.4.1 Classification of Underlying Shares

Stock options and similar instruments are classified as liabilities if the underlying shares are classified as liabilities. For example, if the underlying shares of an option award have repurchase features, an entity would first consider whether to classify the underlying shares as liabilities under ASC 718. See Section 5.3 for guidance on the classification of shares with repurchase features. While grantees generally begin to bear the risks and rewards of share ownership when stock awards vest, they do not do so when stock options vest. Rather, grantees begin to bear the risks and rewards of share ownership when the stock options are exercised and the underlying shares are issued or issuable.

5.4.2 Cash Settlement Features

When stock option awards contain cash settlement features, an entity should perform the steps indicated in the table and decision tree below. Note that these steps only apply to stock options and similar instruments subject to ASC 718 that contain features that transfer cash or other assets upon settlement. They therefore do not apply to the following awards:

Stock options and similar instruments that will be settled upon the issuance of shares that themselves must be classified as liabilities under ASC 718-10-25-11(a) and 25-12. See the previous section.
Share-based payment awards of puttable or callable shares subject to ASC 718. Such awards must be classified in accordance with ASC 718-10-25-9 and 25-10. See Section 5.3 for guidance on determining the classification of puttable and callable stock awards. ASC 718-10-25-9 and 25-10 also apply to stock options and similar instruments in which the underlying shares are puttable or callable. The grantee does not begin to bear the risks and rewards normally associated with share ownership of such instruments until they are exercised.

The table and decision tree below outline an entity’s step-by-step analysis in determining the classification of stock options and similar instruments with cash settlement features.

Determining the Classification of Employee Stock Options and Similar Instruments With Cash Settlement Features
Step	Question	Answer
1	Is cash settlement required, or can the grantee elect either cash or share settlement of the stock option or similar instrument (i.e., is the method of settlement within the grantee’s control)?	If yes, proceed to step 1a. If no, proceed to step 2.
	a. Is the requirement to cash settle or the grantee’s election to cash settle contingent on the occurrence of an event?	If yes, proceed to step 1b. If no, classify the stock option or similar instrument as a share-based liability.
	b. If the requirement to cash settle or the grantee’s election to cash settle is contingent on the occurrence of an event, is the contingent event within the grantee’s control (e.g., voluntary termination of employment)?	If yes, classify the stock option or similar instrument as a share-based liability. If no, proceed to step 1c.
	c. If the requirement to cash settle or the grantee’s election to cash settle is contingent on the occurrence of an event that is not within the grantee’s control (e.g., a change in control), is it probable that the contingent event will occur?	If yes, classify the stock option or similar instrument as a share-based liability. If no, proceed to step 2.
2	Can the entity choose the method of settlement (i.e., cash or share settlement) of the stock option or similar instrument?	If yes, proceed to step 2a. If no, proceed to step 3.
	a. Is the entity’s election contingent on the occurrence of an event?	If yes, proceed to step 2b. If no, proceed to step 2c.
	b. If the entity’s election is contingent on the occurrence of an event, is the contingent event solely within the grantee’s control or is it probable that the event will occur?	If yes, proceed to step 2c. If no, proceed to step 3.
	c. Does the entity have the intent and ability to settle the stock option or similar instrument in the entity’s shares?	If yes, proceed to step 3. If no, classify the stock option or similar instrument as a share-based liability.
3	Is temporary-equity classification of the stock option or similar instrument required under SAB Topic 14.E? This step applies to SEC registrants, and non-SEC registrants may elect not to apply it.	If yes, classify the stock option or similar instrument outside of permanent equity as temporary (or mezzanine) equity. If no, classify the stock option or similar instrument as permanent equity.

5.4.2.1 Noncontingent Cash Settlement Features (Including Tandem and Combination Awards)

Many cash settlement features are not contingent on the occurrence of an event. If an entity is required to settle stock options or similar instruments in cash or other assets (e.g., cash-settled SARs), the awards should be classified as liabilities. Similarly, if the grantee can elect either cash or share settlement of stock options or similar instruments (e.g., tandem awards), the awards should be classified as liabilities. ASC 718 provides the examples below of tandem and combination awards for which the grantee can elect the method of settlement.

ASC 718-10

Example 7: Tandem Awards

55-116 A tandem award is an award with two or more components in which exercise of one part cancels the other(s). In contrast, a combination award is an award with two or more separate components, all of which can be exercised. The following Cases illustrates one aspect of the guidance in paragraph 718-10-25-15:

Share option or cash settled stock appreciation rights (Case A)
Phantom shares or share options (Case B).

55-116A Cases A and B of this Example (see paragraphs 718-10-55-117 through 55-130) describe employee awards. However, the principles on accounting for employee awards, except for compensation cost attribution, are the same for nonemployee awards. Therefore, the guidance in these Cases may serve as implementation guidance for nonemployee awards.

55-116B Compensation cost attribution for awards to nonemployees may be the same as or different from the attribution for the employee awards in Case A (see paragraph 718-10-55-119) and Case B (see paragraph 718-10-55-130). 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 the Cases 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 transactions.

Case A: Share Option or Cash Settled Stock Appreciation Rights

55-117 This Case illustrates the accounting for a tandem award in which employees have a choice of either share options or cash-settled stock appreciation rights. Entity T grants to its employees an award of 900,000 share options or 900,000 cash-settled stock appreciation rights on January 1, 20X5. The award vests on December 31, 20X7, and has a contractual life of 10 years. If an employee exercises the stock appreciation rights, the related share options are cancelled. Conversely, if an employee exercises the share options, the related stock appreciation rights are cancelled.

55-118 The tandem award results in Entity T’s incurring a liability because the employees can demand settlement in cash. If Entity T could choose whether to settle the award in cash or by issuing stock, the award would be an equity instrument unless Entity T’s predominant past practice is to settle most awards in cash or to settle awards in cash whenever requested to do so by the employee, indicating that Entity T has incurred a substantive liability as indicated in paragraph 718-10-25-15. In this Case, however, Entity T incurs a liability to pay cash, which it will recognize over the requisite service period. The amount of the liability will be adjusted each year to reflect changes in its fair value. If employees choose to exercise the share options rather than the stock appreciation rights, the liability is settled by issuing stock.

55-119 The fair value of the stock appreciation rights at the grant date is $12,066,454, as computed in Example 1 (see paragraph 718-30-55-1), because the value of the stock appreciation rights and the value of the share options are equal. Accordingly, at the end of 20X5, when the assumed fair value per stock appreciation right is $10, the amount of the liability is $8,214,060 (821,406 cash-settled stock appreciation rights expected to vest × $10). One-third of that amount, $2,738,020, is recognized as compensation cost for 20X5. At the end of each year during the vesting period, the liability is remeasured to its fair value for all stock appreciation rights expected to vest. After the vesting period, the liability for all outstanding vested awards is remeasured through the date of settlement.

Case B: Phantom Shares or Share Options

55-120 This Case illustrates a tandem award in which the components have different values after the grant date, depending on movements in the price of the entity’s stock. The employee’s choice of which component to exercise will depend on the relative values of the components when the award is exercised.

55-121 Entity T grants to its chief executive officer an immediately vested award consisting of the following two parts:

1,000 phantom share units (units) whose value is always equal to the value of 1,000 shares of Entity T’s common stock
Share options on 3,000 shares of Entity T’s stock with an exercise price of $30 per share.

55-122 At the grant date, Entity T’s share price is $30 per share. The chief executive officer may choose whether to exercise the share options or to cash in the units at any time during the next five years. Exercise of all of the share options cancels all of the units, and cashing in all of the units cancels all of the share options. The cash value of the units will be paid to the chief executive officer at the end of five years if the share option component of the tandem award is not exercised before then.

55-123 With a 3-to-1 ratio of share options to units, exercise of 3 share options will produce a higher gain than receipt of cash equal to the value of 1 share of stock if the share price appreciates from the grant date by more than 50 percent. Below that point, one unit is more valuable than the gain on three share options. To illustrate that relationship, the results if the share price increases 50 percent to $45 are as follows.

55-124 If the price of Entity T’s common stock increases to $45 per share from its price of $30 at the grant date, each part of the tandem grant will produce the same net cash payment (ignoring transaction costs) to the chief executive officer. If the price increases to $44, the value of 1 share of stock exceeds the gain on exercising 3 share options, which would be $42 [3 × ($44 – $30)]. But if the price increases to $46, the gain on exercising 3 share options, $48 [3 × ($46 – $30)], exceeds the value of 1 share of stock.

55-125 At the grant date, the chief executive officer could take $30,000 cash for the units and forfeit the share options. Therefore, the total value of the award at the grant date must exceed $30,000 because at share prices above $45, the chief executive officer receives a higher amount than would the holder of 1 share of stock. To exercise the 3,000 options, the chief executive officer must forfeit the equivalent of 1,000 shares of stock, in addition to paying the total exercise price of $90,000 (3,000 × $30). In effect, the chief executive officer receives only 2,000 shares of Entity T stock upon exercise. That is the same as if the share option component of the tandem award consisted of share options to purchase 2,000 shares of stock for $45 per share.

55-126 The cash payment obligation associated with the units qualifies the award as a liability of Entity T. The maximum amount of that liability, which is indexed to the price of Entity T’s common stock, is $45,000 because at share prices above $45, the chief executive officer will exercise the share options.

55-127 In measuring compensation cost, the award may be thought of as a combination — not tandem — grant of both of the following:

1,000 units with a value at grant of $30,000
2,000 options with a strike price of $45 per share.

55-128 Compensation cost is measured based on the combined value of the two parts.

55-129 The fair value per share option with an exercise price of $45 is assumed to be $10. Therefore, the total value of the award at the grant date is as follows.

55-130 Therefore, compensation cost recognized at the date of grant (the award is immediately vested) would be $30,000 with a corresponding credit to a share-based compensation liability of $30,000. However, because the share option component is the substantive equivalent of 2,000 deep out-of-the-money options, it contains a derived service period (assumed to be 2 years). Hence, compensation cost for the share option component of $20,000 would be recognized over the requisite service period. The share option component would not be remeasured because it is not a liability. That total amount of both components (or $50,000) is more than either of the components by itself, but less than the total amount if both components (1,000 units and 3,000 share options with an exercise price of $30) were exercisable. Because granting the units creates a liability, changes in the liability that result from increases or decreases in the price of Entity T’s share price would be recognized each period until exercise, except that the amount of the liability would not exceed $45,000.

Many compensation arrangements include payments of both equity and cash. In some cases, the cash component represents a liability-classified share-based payment award that is accounted for separately from the equity-classified component (i.e., as a combination award). The examples below illustrate the accounting for arrangements that are settled partially in cash and partially in equity.

Example 5-14

Entity A grants to an executive restricted stock and stock options that vest at the end of four years (cliff vesting). The award requires A to reimburse the executive in cash for federal income taxes at a rate of 37 percent when the employee is taxed, which is when the employee vests in the restricted stock or exercises its stock options. Provided that all the criteria for equity classification have been met, the restricted stock and stock options will be separately accounted for as equity-classified share-based payment awards under ASC 718. In addition, because A is required to pay the executive in cash amounts that are indexed to the fair value of the underlying stock, those obligations are separately accounted for as liability-classified awards under ASC 718. The tax obligation associated with the restricted stock is accounted for as cash-settled RSUs and measured on the basis of 37 percent of the value of the underlying restricted stock. In addition, the tax obligation associated with the stock options is accounted for as cash-settled SARs. Both liability-classified awards are required to be remeasured in each reporting period and recognized as compensation cost.

Example 5-15

Entity A establishes an entity-wide bonus program that provides each employee with an annual targeted compensation rate. At the beginning of every year, each employee is notified of his or her targeted rate and the composition in shares of common stock and cash, which both vest over a one-year period (cliff vesting). Employee B’s targeted rate is $100,000 with a 50/50 equity-to-cash split, and each share is worth $50; therefore, B will receive a cash bonus of $50,000 and a stock award worth $50,000 (1,000 shares, which is $50,000 divided by the stock price of $50). If, upon vesting, the value of B’s total compensation is below the targeted rate, B will receive an additional cash bonus for the difference. If the stock price increases from the grant date, no additional cash bonus is paid. However, if the stock price decreases from the grant date, B will receive a cash bonus equal to the decrease in value. For example, if B receives stock worth $60,000 on the vesting date, B will not receive any additional cash bonus. By contrast, if the stock is worth $40,000 on the vesting date, B will receive an additional cash bonus of $10,000. In effect, A has guaranteed that the employee will be paid a minimum of $100,000 in cash and equity upon earning the bonus.

The $50,000 cash bonus is not subject to ASC 718 since it is not indexed to A’s equity value (i.e., it is recognized as a fixed-price liability over the one-year vesting period). Provided that all the criteria for equity classification have been met, the restricted stock award will be separately accounted for as an equity-classified award under ASC 718 and recognized as compensation cost over the one-year requisite service period. The cash-settled guarantee is indexed to A’s common stock and is therefore accounted for as a put option under ASC 718. That cash-settled share-based liability should be remeasured in each reporting period and recognized as compensation cost over the one-year requisite service period.

An entity that can elect a settlement method should consider the guidance in ASC 718-10-25-15, which requires an entity to continually evaluate its intent and ability to settle in shares. In addition, an entity’s past practices related to cash settlement could indicate that the awards should be classified as substantive liabilities. Section 5.6 discusses considerations for an entity that can choose the method of settlement in determining the classification of options and similar instruments.

5.4.2.2 Contingent Cash Settlement Features

An entity should analyze a contingent cash settlement feature that becomes exercisable only upon the occurrence of a specified future event (i.e., the triggering event) to determine whether the triggering event is within the control of the grantee. Triggering events within the grantee’s control should be ignored in the entity’s analysis, and the entity should assess the options or similar instruments as if the triggering event has already occurred. Options or similar instruments that require or permit the grantee to cash settle the options or similar instruments must be classified as liabilities. Alternatively, options or similar instruments that permit the entity to choose settlement in cash or shares are not classified as liabilities unless they are substantive liabilities under ASC 718-10-25-15.

ASC 718-10-25-11 states that if a contingent cash settlement feature becomes exercisable upon a triggering event that is not within the control of the grantee, and the grantee can choose the method of settlement or the entity is required to settle in cash or other assets, the stock option or similar instrument will not result in liability classification if it is not probable that the triggering event will occur. The assessment of probability is required while an award is within the scope of ASC 718 and is generally performed on an individual-grantee basis. For example, a stock option that can require cash settlement upon a change in control should not be classified as a liability unless a change in control is considered probable. Generally, a change in control is not considered probable until the event that triggers it has occurred (e.g., when a business combination has been consummated).

If a contingent cash settlement feature becomes exercisable upon a triggering event that is not within the control of the grantee, and the entity can determine the method of settlement, the stock option or similar instrument will not result in liability classification if it is not probable that the event will occur. The probability assessment is required while an award is within the scope of ASC 718 and is generally performed on an individual-grantee basis. If it becomes probable that the triggering event will occur, the entity must consider the substantive terms of the option or similar instrument under ASC 718-10-25-15, including the entity’s intent and ability to settle the option or similar instrument in shares and the entity’s past practices of settling options or similar instruments. Section 5.6 discusses considerations for an entity that can choose the method of settlement in determining the classification of options and similar instruments.

Note that SEC registrants must consider the requirements of ASR 268 (FRR Section 211) and ASC 480-10-S99-3A, as discussed in SAB Topic 14.E. In accordance with that guidance, SEC registrants must present outside of permanent equity (i.e., as temporary or mezzanine equity) options and similar instruments (otherwise classified as equity) that are subject to cash settlement features that are not solely within the control of the issuer. Temporary equity classification is required even if the options or similar instruments otherwise qualify for equity classification under ASC 718 (e.g., an option that can be cash settled upon a change in control). See Section 5.10 for a discussion and example of the application of ASR 268 and ASC 480-10-S99-3A to stock options with a contingent cash settlement feature.

The redemption value at issuance is based on the cash settlement feature of the option or similar instrument. For example, the redemption value of an option that can be cash settled at intrinsic value is the intrinsic value of the option. Thus, if a stock option is granted at-the-money, its initial carrying value would be zero. Subsequent remeasurement in temporary equity is not required under ASC 480-10-S99-3A unless it is probable that the triggering event will occur, in which case the option or similar instrument would be reclassified as a liability under ASC 718. As indicated in ASC 718-10-35-15, an entity would account for a reclassified stock option or similar instrument in essentially the same way it would account for a modification that changes the award’s classification from equity to liability. See Section 6.8.1 for a discussion and examples of the accounting for the modification of an award that changes the award’s classification from equity to liability.

An entity does not need to consider ASC 480-10-S99-3A if it can choose the method of settlement (i.e., cash or share settlement) since that guidance applies only to awards with redemption features not solely within the control of the issuer. An option or similar instrument with terms that allow the entity to choose the method of settlement will never be classified as temporary equity.

5.4.2.3 Early Exercise of a Stock Option or Similar Instrument

An early exercise refers to a grantee’s ability to change his or her tax position by exercising an option or similar instrument and receiving shares before the award is vested.

Because the awards are exercised before vesting, if the grantee ceases to provide goods or services before the end of this period, the entity issuing the shares usually can repurchase the shares for either of the following:

The lesser of the fair value of the shares on the repurchase date or the exercise price of the award.
The exercise price of the award.

The purpose of the repurchase feature is effectively to require the grantee to provide goods or services to receive any economic benefit from the award. Because the repurchase feature functions as a forfeiture provision, an entity would not consider the provisions of ASC 718-10-25-9 and 25-10 to determine the classification of the award. In addition, because the early exercise is not considered to be a substantive exercise for accounting purposes, the payment received by the entity for the exercise price should generally be recognized as a deposit liability. See Section 3.4.3 for additional discussion on an early exercise of a stock option or similar instrument.

5.4.3 Net Share Settlement Features

Some share-based payment arrangements contain features that allow grantees to net share settle vested options or similar instruments. These features, which are sometimes referred to as stock option pyramiding, phantom stock-for-stock exercises, or immaculate cashless exercises, allow the grantee to exercise an option without having to pay the exercise price in cash. As a result of the settlement feature, the grantee receives upon exercise a number of shares with a fair value equal to the intrinsic value of the exercised options.

A net share settlement feature by itself does not result in liability classification of an option. An option that can be net share settled is no different from a share-settled SAR and is not required to be classified as a share-based liability. However, an option may include other features that result in liability classification. See Section 5.4.2 for guidance on determining the classification of stock options with cash settlement features.

5.4.4 Broker-Assisted Cashless Exercise

ASC 718-10 — Glossary

Broker-Assisted Cashless Exercise

The simultaneous exercise by a grantee of a share option and sale of the shares through a broker (commonly referred to as a broker-assisted exercise).

Generally, under this method of exercise:

The grantee authorizes the exercise of an option and the immediate sale of the option shares in the open market.
On the same day, the entity notifies the broker of the sale order.
The broker executes the sale and notifies the entity of the sales price.
The entity determines the minimum statutory tax-withholding requirements.
By the settlement day (generally three days later), the entity delivers the stock certificates to the broker.
On the settlement day, the broker makes payment to the entity for the exercise price and the minimum statutory withholding taxes and remits the balance of the net sales proceeds to the grantee.

ASC 718-10

25-16 A provision that permits grantees to effect a broker-assisted cashless exercise of part or all of an award of share options through a broker does not result in liability classification for instruments that otherwise would be classified as equity if both of the following criteria are satisfied:

The cashless exercise requires a valid exercise of the share options.
The grantee is the legal owner of the shares subject to the option (even though the grantee has not paid the exercise price before the sale of the shares subject to the option).

25-17 A broker that is a related party of the entity must sell the shares in the open market within a normal settlement period, which generally is three days, for the award to qualify as equity.

The exercise of stock options and similar instruments is often accomplished through a broker. A feature that permits grantees to effect a broker-assisted cashless exercise would not be deemed a cash settlement feature (that could cause liability classification) if the criteria in ASC 718-10-25-16 and 25-17 are met.

In addition, while ASC 718 does not define a “legal owner,” paragraph 245 of EITF Issue 00-23 states:

As the legal owner of the shares, the employee assumes market risk from the moment of exercise4 until the broker effects the sale in the open market. While the period of time that the employee is exposed to such risk may be inconsequential, it is no less of a period of time than might lapse if the employee paid cash for the full exercise price and immediately sold the shares through an independent broker. If the employee were never the legal owner of the option shares, the stock option would be in substance a stock appreciation right for which [liability] accounting is required. If the related-party broker acquires the shares for its own account rather than selling the shares in the open market, the grantor has, in effect, paid cash to an employee to settle an award, which is a transaction for which compensation expense should be recognized. Conversely, the sale of the option shares in the open market provides evidence that the marketplace, not the grantor (through its affiliate), has acquired the option shares.

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4 Under many cashless exercise programs, the broker will notify the employee if the aggregate sales price for the option shares is less than the aggregate exercise price. In that situation, the employee may elect not to exercise the options. As a result, the moment of exercise is deemed to be the moment that the shares are sold.

While EITF Issue 00-23 was not codified in ASC 718, we believe that it is appropriate for entities to consider in determining whether the grantee is the legal owner of the shares.

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