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2.2 Stock-based compensation measurement basis and objective
Publication date: 15 Sep 2023
us Stock-based compensation guide
ASC 718 principally requires the use of the "fair-value-based method" for measuring the value of stock-based compensation. Employee stock options generally are not tradeable in the financial markets and also generally have features and restrictions that differ from those of publicly traded options. Those features and restrictions affect the fair value of employee stock options (e.g., nontransferability and nonhedgeability). Therefore, ASC 718 requires that, in applying the "fair-value-based method," companies use an option-pricing model adjusted to accommodate the unique characteristics of employee stock options.
For the sake of convenience, however, ASC 718 generally refers to the required measure of stock-based compensation as fair value; that term also distinguishes the measure from other measures, such as intrinsic value and calculated value. In ASC 718 and in this guide, references to fair value mean the "fair-value-based measure" that is determined in accordance with the requirements of ASC 718, rather than the term "fair value" as used in ASC 820, Fair Value Measurement.
ASC 718's measurement objective is to determine the fair value of stock-based compensation at the grant date assuming that employees fulfill the award's vesting conditions and will retain the award. The fair value of an award is the cost to the company of granting the award and should reflect the estimated value of the instruments that the company would be obligated to provide to an employee when the employee has satisfied the service conditions. For most awards, the cost will be measured once at the grant date fair value and will not be adjusted for subsequent changes in fair value.
When determining fair value (in accordance with ASC 718-10-55-10 through ASC 718-10-55-12), companies should take the following steps:
- Step 1: Consider observable market prices of identical instruments (if available), taking into consideration the terms of the instruments and the conditions upon which they were granted.
- Step 2: Consider observable market prices of similar instruments (if available), taking into consideration the terms of the instruments and the conditions upon which they were granted. Management should assess whether an instrument is similar to marketplace instruments, basing its conclusion on an analysis of the instrument's terms, along with an evaluation of other relevant facts and circumstances.
- Step 3: If identical or similar instruments are not available in the marketplace, use a valuation technique, such as an option-pricing model (e.g., Black-Scholes, lattice/binomial). The valuation technique should be:
- Consistent with ASC 718's fair value measurement objective.
- Based on established principles of economic theory.
- Generally accepted by experts (i.e., broadly acknowledged and supported by valuation experts in both academia and practice).
- Capable of reflecting any and all substantive characteristics of the award (except for characteristics that are explicitly excluded by ASC 718, such as reload features, as discussed in SC 2.4).
SAB 120 - "Spring-loaded" awards
SEC Staff Accounting Bulletin No. 120 (SAB 120) expresses the SEC staff’s views on accounting for share-based awards under ASC 718 that are granted shortly before release of material non-public information that is expected to result in a material increase in share price (described in SAB 120 as “spring-loaded” awards). In these situations, SAB 120 indicates that companies are expected to consider whether adjustments to the observable market price of the underlying shares and estimates of expected volatility are necessary to determine the fair value of the share-based payment transactions.
SAB 120 also emphasizes the need for strong corporate governance and internal controls when granting equity awards, and details various disclosures that should be made when spring-loaded awards are granted.
2.2.1 Use of market instruments to value employee stock options
Although ASC 718 suggests that employee stock options may be valued by reference to similar instruments in the marketplace, this approach is uncommon in practice. Most employee awards have unique features that are difficult, if not impossible, to replicate in a third-party arrangement. In the past, a limited number of companies tried to create a marketplace in which they could trade instruments that are similar to employee stock options so that they could use observable market prices instead of an option-pricing model to estimate the fair value of their employee stock options.
In September 2005, the SEC’s Office of Economic Analysis (OEA) issued a memorandum that discusses potential instrument designs that may be used in developing a market instrument to estimate the fair value of employee stock options. The OEA memorandum identifies three key elements of a market-instrument approach: (1) instrument design, (2) a credible information plan that enables prospective buyers and sellers to price the instrument, and (3) a market pricing mechanism through which the instrument can be traded to establish a price. The OEA memorandum does not discuss information plans and market pricing mechanisms in detail, but discusses two possible approaches to instrument design, referred to as the “tracking approach” and the “terms and conditions approach.” In general, OEA concludes that an instrument designed under the tracking approach could produce a fair value estimate that reflects the cost to the company of granting the stock option. However, it concludes that, given the inherent difficulty in replicating the employer-employee relationship, an instrument designed under the terms and conditions approach will likely not produce a reasonable estimate of the fair value of employee stock options consistent with the measurement objective of ASC 718.
There are significant issues that a company needs to address in order to successfully implement a market instrument approach, including the development of an information plan that is easily accessible to all market participants and enables prospective buyers and sellers to price the instrument, as well as a market pricing mechanism that has adequate participation by willing buyers and sellers. Based on the views expressed by the SEC staff, a market instrument approach that results in a fair value that is significantly different from the fair value obtained from an option pricing model could face skepticism from the SEC staff, especially in the early stages of the development of market instruments.
2.2.2 Option-pricing models
The option-pricing model used to measure fair value of an award and the specific assumptions input into the model have a direct effect on the amount of compensation cost recognized for the award. SC 8 provides an overview of how to select an option-pricing model and the supporting financial theory, discusses the required assumptions, and explains the differences between the various types of models.
2.2.3 Inability to estimate fair value of a stock-based award
A company should be able to reasonably estimate the fair value of stock-based compensation awards on the grant date. When, in rare circumstances, the complexity of an award's terms makes it impossible to reasonably estimate the award's fair value on the grant date, a company will measure compensation cost by using the award's intrinsic value each reporting period through the date of exercise or other settlement. Even if the company were to later conclude that it can reasonably estimate the fair value of the award (e.g., if a new valuation technique was developed), the company would continue using the intrinsic-value method until the award is settled.
Remeasuring awards at their intrinsic value each reporting period may result in significant fluctuations to compensation cost, especially if the underlying stock price were to increase.
2.2.4 Restricted stock award
The term "restricted stock" is commonly used to describe two different arrangements: (1) shares that are legally restricted as to transfer and may be held by any shareholder, including shares issued to employees and (2) "nonvested shares" that are share awards issued to employees and subject to vesting conditions. ASC 718 distinguishes between "nonvested shares" and "restricted shares." This guide generally refers to nonvested shares as restricted stock.
2.2.4.1 Nonvested share award
The fair value of restricted stock and restricted stock units (RSUs) is generally measured as the grant-date price of the company's shares. If employees are not entitled to dividends declared on the underlying shares while the restricted stock or RSU is unvested, the grant-date fair value of the award is measured by reducing the grant-date price of the company's shares by the present value of the dividends expected to be paid on the underlying shares during the requisite service period, discounted at the appropriate risk-free interest rate. Conversely, if dividends are paid during the vesting period or accumulated and paid to the employee upon vesting, the grant-date fair value of the award should not be reduced.
See SC 2.9 for guidance on accounting for dividends received by holders of restricted stock or RSUs.
2.2.4.2 Restricted share award
As the term is used in ASC 718, "restricted shares," as distinguished from nonvested shares discussed in SC 2.2.4.1, refers to shares that are owned by the employee that contain restrictions on sale or transfer, such as a share whose sale is contractually or governmentally prohibited for a specified period of time after the employee has a vested right to it. These types of restrictions are often referred to as "post-vesting restrictions." A restricted share is measured at its fair value, which is the same amount at which a similarly restricted share would be issued to third parties. In other words, the effect of the post-vesting restriction is considered in determining the fair value of the award; however, ASC 718-10-55-5 notes that if shares are traded in an active market, post-vesting restrictions may have little, if any, effect on the value of the shares.
The definition of a restriction in ASC 718 is a prohibition on resale, rather than a limitation on resale. For example, securities laws may prohibit the sale of a security to other than qualified institutional buyers or in other exempt transactions (e.g., a Rule 144A exempt offering). Such a limitation does not represent a prohibition as contemplated by the definition of a restriction in ASC 718. Therefore, a limitation such that the shares can be transferred only to a limited population of investors should not be considered in the estimate of fair value.
Example SC 2-1 illustrates the definition of restricted shares.
EXAMPLE SC 2-1
Share award with sale restrictions
SC Corporation grants a vested share award that restricts an employee from selling the shares until the employee terminates employment.
Are the shares considered "restricted shares"?
Analysis
No. ASC 718-10-20 defines a restricted share as "a share for which sale is contractually or governmentally prohibited for a specified period of time." If the restrictions lapse on a voluntary termination then the shares are not subject to a contractual or governmental prohibition on sale, as the employee could choose to leave employment and sell the shares. SC Corporation should determine fair value of the award based on the price of SC Corporation's shares on the grant date and recognize compensation cost immediately, as the shares are fully vested.
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