If the plan is compensatory, how is compensation measured?

The fundamental principle in Statement 123(R) is that compensation is measured based on the fair value of the award. For shares, fair value is measured based on the quoted market price of the shares, or appraised fair value if the shares are not traded. For options, fair value is estimated using a recognized option-pricing model that at a minimum incorporates all of the following assumptions, which are reflective of contractual, market-based or estimated features:

• Current fair value of underlying shares
• Option exercise price
• Expected term of option
• Expected dividend yield over the expected term of the option
• Risk-free interest rate over the expected term of the option
• Expected volatility of the stock price over the expected term of the option

From a practical standpoint, companies should regularly review the assumptions used in estimating fair value for options. For those assumptions that are contractual (e.g., exercise price and maximum term) along with those that are market-based (e.g., underlying stock price and risk-free interest rate), an assessment should be done individually for each grant. For those assumptions that are estimated (e.g., expected term; expected volatility and dividend yield), assumptions should be updated annually unless there is a significant change in the company's business during the year (e.g., change in operations or in the workforce) that would warrant a re-assessment.

Private company alternatives

To reduce compliance costs for private2 companies, Statement 123(R) provides certain measurement alternatives. For stock options classified as equity awards, private companies that cannot practicably estimate the expected volatility of their own stock price, because transactions are too infrequent, are permitted to substitute the historical volatility of a relevant sector index. This method is known as "calculated value." While Statement 123(R) does not point to specific indices (of which there are many available) other than the Dow Jones Indices, it indicates that a company should select an index based upon companies that have operations that are most similar to its own operations. A broad-based index would be inappropriate, because the diversity associated with such an index would not be reflective of the specific industry sector(s) that the company operates in. The calculated value method should be applied using the daily historical closing values of the index over a period that equals the expected term of the option.

For liability awards, private companies may choose to measure compensation based on intrinsic (in-the-money) value rather than fair value or calculated value. Cumulatively, this will result in the same compensation expense, because fair value and calculated value converge on intrinsic value at settlement, but it avoids the costs of applying option-pricing models. However, fair value is the preferred method for justifying a voluntary change in a accounting principle under FASB Statement No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3. In addition, the choice in measurement methods is a policy choice that should be applied consistently.

Inability to estimate fair value

In the rare instance that an equity instrument has such unusual terms that a company is not able to reasonably estimate fair value at grant date, Statement 123(R) requires application of the intrinsic value method. The instrument would be remeasured at each reporting date through exercise or settlement. Note: The company would continue to use the intrinsic value method even if it subsequently concludes that it has become possible to reasonably estimate fair value.

What option-pricing models are permitted?

Statement 123(R) describes two classes of option-pricing models: closed-form models (e.g., Black-Scholes-Merton) and lattice models (e.g., binomial). Under the final standard, either class of model is acceptable. Lattice models offer more flexibility to accommodate the unique features of employee stock options and, as a result, potentially offer more precise estimates of fair value. However, lattice models require more inputs than closed-form models, and many employers will not have the information readily available.

So which option pricing model should companies use?

In our opinion, a closed-form model like Black-Scholes-Merton is a more cost effective choice for most companies. Lattice models require significantly more effort to develop assumptions. Some valuation specialists believe that the extra effort is worthwhile, because they believe that the estimated fair values generated by lattice models are more precise and tend to be lower that the estimated fair values generated by closed-form models. We have heard mixed reports about whether lattice models generate lower fair values and, if so, by how much. We believe that some of the greater precision of lattice models can be achieved in closed-form models by refining the assumptions about expected volatility and expected term, at less cost than applying lattice models. Further, because neither lattice models nor closed-form models take into account exercise behavior triggered by individual employees' personal financial situations, we question whether the purported greater precision of lattice models is as great as some proponents believe.

How Statement 123(R) differs from Statement 123

Whereas Statement 123 permits an employer to choose between the intrinsic value model of Opinion 25 and the fair value model of Statement 123, Statement 123(R) eliminates that choice and requires use of the fair value model. Statement 123(R) also refines the fair value model as compared to Statement 123 as follows:

• Statement 123(R) provides more guidance on how to develop the assumptions needed to apply lattice models.
• Statement 123(R) provides more guidance on the most difficult assumption in option-pricing models-the expected volatility of the stock price. Estimating volatility is discussed in the next section.
• Liability awards are measured at intrinsic value under Statement 123. Under Statement 123(R), they are measured at fair value. Cumulatively the same compensation expense is recorded, because at exercise or settlement date fair value and intrinsic value are the same. However, for option-like liability awards, the interim estimates of compensation will differ.
• Finally, the alternative method for private companies is different. Under Statement 123, the alternative to fair value for private companies is to measure options using "minimum value" at grant date. Minimum value is computed by applying the Black-Scholes-Merton model with an expected stock price volatility of zero. Statement 123(R) requires fair value measurement but allows private companies that are unable to reasonably estimate fair value to use the "calculated value" method, as discussed above.

Continue Reading - How is the expected volatility of the stock price estimated?

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