Stock Option Valuation


Financial Accounting Standards Board (FAS 123R) now requires financial institutions, public institutions, and private companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation issued to employees. FAS 123R applies to all share-based payment transactions for acquiring goods or services, including:

  • Issuance of share options (stock options)
  • Incurring liabilities whose settlements are based, at least in part, on the price of the entity’s shares or other equity instruments
  • Settling obligations by issuing the entity’s equity shares or other equity instruments

The only exception: Shares held in an ESOP that are still accounted for in accordance with the AICPA Statement of Position No. 93-6, Employers’ Accounting for Employee Stock Ownership Plans, (SOP 93-6).

The original FAS 123 encouraged the use of grant-date fair value method of accounting for equity-based compensation.  However, it provided financial institutions the opportunity to continue using the intrinsic-value method provided by APB No. 25.  APB No. 25 was applicable as long as the footnotes to the financial statements disclosed what the pre-forma impact on net income would have been had the preferable fair value method been utilized.  Most institutions used this approach, as no compensation costs were recognized in the income statement. FAS 123R replaced both FAS 123 and APB No. 25.  Compensation costs related to equity-based compensation must now be recognized in the income statement.

FAS 123R does not require a specific valuation technique to determine the grant-date fair value of employee stock options and other equity-based compensation issued to employees.  Estimate the value using option pricing models adjusted for the unique characteristics of the instruments.  Valuation models that meet the FAS 123R criteria include:

  • Lattice models, such as a binomial model
  • Closed-form models, such as the Black-Scholes model. 

The compensation cost recognized in the income statement for equity-based awards will generally be recognized over the vesting period based on the grant-date fair value of the award.

FAS 123 allowed forfeitures to be accounted for, either by estimating the number of forfeitures at the grant date or accounting for the effects of the forfeitures when they occurred.  FAS 123R removes this option and requires estimation of forfeitures at the date of grant with the possibility of subsequent revisions.  In addition, FAS 123R generally requires expensing of employee stock purchase plans (ESPP).

Historically, ESPP permitted participants to purchase an employer institution stock at a discount up to 15% and the institution did not recognize compensation cost on the income statement.  An employee would be permitted to purchase employer shares at a price of 85% of the lower of the stock price either at the end of the purchase period or at the beginning of the look-back period, which is generally six months.  FAS 123R now requires institutions to record compensation cost equal to the sum of any discount and the fair value of the look-back.  If the institution’s plan limits the discount to 5% or less and meets certain other criteria, the ESPP will not be considered compensatory under FAS 123R, and compensation cost will not be required to be recorded on the income statement

FAS 123R is a complex statement that contains many new requirements and issues not fully addressed in this summary.  We’d be happy to review this with you in further detail.


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