FASB Releases Equity-Based Compensation Proposal

This morning, the Financial Accounting Standards Board finally released its long-awaited proposal to require companies to recognize the cost of employee stock compensation in financial statements.

The "exposure draft," available for download in the column at right, covers a wide range of equity-based compensation arrangements.

Key Elements

Under the Board’s proposal, all forms of share-based payments to employees—including employee stock options—would be treated the same as other forms of compensation by recognizing the related cost in the income statement.

The expense of the award would generally be measured at fair value at the grant date. As you likely know, current accounting guidance requires that the expense relating to so-called "fixed plan employee stock options" need only be disclosed in the footnotes to the financial statements. That being said, approximately 500 U.S. public companies already expense options, or have announced they plan to do so.

Crooch

According to FASB member Michael Crooch, who serves as the Board collaborator on

the project, many of the exposure draft’s proposed requirements are similar to previous guidance, but "the Board has carefully readdressed each aspect of the accounting and has proposed changes to respond to the needs of financial statement users."

Differences

The key difference between the proposed statement and current practice is that it would eliminate the alternative to use an "intrinsic value" method of accounting. Under current board opinions and statements, issuing stock options to employees generally resulted in recognition of no compensation cost.

The proposed statement would require public companies to recognize the cost of employee services received in exchange for equity instruments, based on the grant-date fair value of those instruments. According to the Board, the proposal would also affect the pattern in which compensation cost would be recognized, the accounting for employee share purchase plans, and the accounting for the income tax effects of such transactions.

The proposal also moves the Board's convergence project closer to fruition; in recent months, the IASB and Canada have issued requirements to expense stock options.

The comment period for the exposure draft ends June 30, 2004, and the Board has stated that it plans to hold public roundtable meetings to gather additional input on the proposal. FASB has already held more than 35 public meetings on the topic.

Some key concepts are excerpted below, the complete details are available for download from the column above, right:

Effective Date

This Statement shall be effective for awards that are granted, modified, or settled in fiscal years beginning after:

December 15, 2004, for public entities and nonpublic entities that used the fair-value-based method of accounting under the original provisions of Statement 123 for recognition or pro forma disclosure purposes and

December 15, 2005, for all other nonpublic entities. Earlier application is encouraged provided that financial statements for those earlier years have not yet been issued. Retrospective application of this Statement is not permitted.

Grant Date Fair Value

For public entities, the cost of employee services received in exchange for equity instruments would be measured based on the grant-date fair value of those instruments (with limited exceptions). That cost would be recognized over the requisite service period (often the vesting period). Generally, no compensation cost would be recognized for equity instruments that do not vest.

For public entities, the cost of employee services received in exchange for liabilities would be measured initially at the fair value of liabilities and would be remeasured subsequently at each reporting date through settlement date. The pro rata change in fair value during the requisite service period would be recognized over that period, and the change in fair value after the requisite service period is complete would be recognized in the financial statements in the period of change.

The grant-date fair value of employee share options and similar instruments would be estimated using option-pricing models adjusted for the unique characteristics of those options and instruments (unless observable market prices for the same or similar options are available).

Valuation

Estimates and assumptions should reflect information that is (or would be) available to form the basis for an amount at which the instruments being valued would be exchanged.

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 employees shall be estimated by using a valuation technique that:

is applied in a manner consistent with the fair value measurement objective and the other requirements of this Statement,

is based on established principles of financial economic theory and generally accepted by experts in that field ... and

reflects any and all substantive characteristics of the instrument

Models: Black-Scholes Vs. "Lattice"

Several valuation techniques, including a lattice model (an example of which is a binomial model) and a closed-form model (an example of which is the Black-Scholes-Merton formula) meet the criteria required by this Statement for estimating the fair values of employee share options and similar instruments.

The selection of a valuation model will depend on the substantive characteristics of each arrangement and the availability of data necessary to use the model. A valuation model that is more fully able to capture and better reflects those characteristics is preferable and should be used if it is practicable to do so.

... a lattice model can be designed to incorporate certain characteristics of employee share options and similar instruments; it can accommodate changes in dividends and volatility over the option’s contractual term, estimates of expected option exercise patterns during the option’s contractual term, and blackout periods. A lattice model, therefore, is more fully able to capture and better reflects the characteristics of a particular employee share option or similar instrument in the estimate of fair value.

Although a lattice model may be preferable because of its ability to more fully capture and better reflect the characteristics of a particular employee share option or similar instrument in the estimate of fair value, it may not be practicable to use such a model. For example, an enterprise may lack the historical data on employee exercise patterns that could be used within a lattice model in estimating expected option exercises over the option’s contractual term.

Modifications

If an equity award is modified subsequent to the grant date, incremental compensation cost would be recognized in an amount equal to the excess of the fair value of the modified award over the fair value of the original award immediately prior to the modification.

Employee share purchase plans would not be considered compensatory if the terms of those plans were no more favorable than those available to all holders of the same class of shares and substantially all eligible employees could participate on an equitable basis.

Tax Benefits

Excess tax benefits, as defined by this proposed Statement, would be recognized as an addition to paid-in capital. Cash retained as a result of those excess tax benefits would be presented in the statement of cash flows as financing cash inflows. The write-off of deferred tax assets relating to unrealized tax benefits associated with recognized compensation cost would be reported as income tax expense.

Private Companies

This proposed Statement allows nonpublic entities to elect to measure compensation cost of awards of equity share options and similar instruments at intrinsic value through the date of settlement. That election also would apply to awards of liability instruments. This proposed Statement also requires that public entities measure compensation cost of awards of equity share options and similar instruments at intrinsic value through the date of settlement if it is not reasonably possible to estimate their grant-date fair value.

Disclosures

The notes to financial statements of both public and nonpublic entities would disclose the information that users of financial information need to understand the nature of share-based payment transactions and the effects of those transactions on the financial statements.

NOTE: Please note that this is a summary of a proposed FASB proposal, and should not be construed to be a complete or final rule, nor should it be construed to be legal guidance. Please refer to the FASB's Web site for updated and final rule information.