FASB Hands Down Option Expensing Proposal

March 31, 2004 (PLANSPONSOR.com) - The nation's accounting rulemaking body - the Financial Accounting Standards Board (FASB) - has issued an Exposure Draft outlining the compulsory expensing of employee share-based compensation, which includes stock options.

Under the Exposure Draft – Share-Based Payment, an Amendment of FASB Statements No. 123 and 95 – all forms of share-based payments to employees 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.

“The proposal seeks to improve existing accounting rules and provides more complete, higher quality information for investors,” FASB said in a news release.

Currently, companies are only required to disclose the cost of stock options as footnotes to the financial statements.   Some investor groups have argued the current method of accounting for stock options makes it difficult to gauge the effect stock options have on a company’s bottom line.   It was “i n response to requests from investors and many other parties to improve the current accounting standards relating to employee stock compensation in financial statements” that FASB said the Exposure Draft was issued.  

Valuation Method

As for a valuation method, FASB leaves the issue open to the company.   Ultimately, FASB finds the best “evidence of a fair value” are found in the “observable market prices of identical or similar equity or liability instruments in active markets.”   In the absence of such a measure, the Exposure Draft requires the fair value of share-based options be valued using a technique that takes into account “various factors,” which includes:

  • exercise price of the option
  • expected term of the option
  • current price of the underlying share
  • expected volatility of the underlying share price
  • expected dividends on the underlying share
  • risk free interest rate.

Incorporating all of these variables, FASB in Appendix B of the Exposure Draft says, “s everal 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.”

However, among the two, the FASB explains the better estimate of the fair value of an employee share option may be obtained using the lattice model.    That is because the lattice model incorporates an optionee’s expected exercise and expected post-vesting employment termination behavior, whereas a close-form model uses a single weighted-average expected option term.  “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,” FASB said in the Exposure Draft.

The two valuation forms though are necessary, FASB finds, due to the expansive disclosure required to adequately perform the valuations of a lattice model.   For example, a company 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 – such as a nonpublic company that elects to account for employee share options using the fair-value-based method or a newly public company may not have a significant history of share option exercise.   Thus, a firm might find a closed-form might provide a more suitable valuation.

Effective Date

The proposed change in accounting would replace existing requirements under FAS 123, Accounting for Stock-Based Compensation, and APB Opinion No 25, Accounting for Stock Issued to Employees.   The proposed statement would be applied to public entities with fiscal years beginning after December 15, 2004.   The same date applies to nonpublic entities that adopted the fair-value-based method of accounting for pro forma disclosures.   All other nonpublic entities would apply the propose statement for fiscal years beginning after December 15, 2005.

Responses from interested parties wishing to comment on the Exposure Draft must be received in writing by June 30, 2004. Interested parties should submit their comments by email to director@fasb.org , File Reference No. 1102-100.

A copy of the exposure draft is available at  http://www.fasb.org/draft/ed_intropg_share-based_payment.shtml .