CEP LEVEL 3 ACCOUNTING

Measurement of Compensation Cost - Shares tendered to cover tax withholding

ASC 718 also permits the tender of shares to cover required tax withholding payments. However, where shares are tendered from those currently being exercised (in the case of a stock option or SAR) or released (in the case of restricted stock awards or units), the tax withholding must be limited to the maximum individual tax rate in the applicable jurisdiction. Allowing employees to tender exercised or released shares for tax payments in excess of the maximum individual tax rate will trigger liability treatment for the grant in question. Moreover, if the transaction is part of a pattern, or if the terms of the plan specifically allow employees to tender shares for payments in excess of the maximum tax rate, liability accounting may be required for the entire plan.

SAB 107 - Valuations - Changing Valuation Models

ASC 718 permits companies to change the model or technique used to value stock options, particularly when the new model results in a better estimate of option fair value. When changing valuation models or techniques, companies would apply the new valuation method on a prospective basis only. That is, the new model/technique would be applied only to future grants; options granted in the past generally would not be revalued. In Staff Accounting Bulletin No. 107, issued in 2005, the SEC indicates that companies that change valuation models or techniques are not required to file a preferability letter from their auditors with their financial statements (as is required when companies change attribution methods—see chapter 5). The SEC also indicates that companies should not frequently change valuation models or techniques and that, upon implementing such a change, they should disclose the basis for it in the footnotes to their financial statements.

Disclosures

ASC 718 requires companies to provide the following disclosures for their stock compensation plans. Typically, this information is disclosed in aggregate for all of the company's stock plans, but separate disclosure is required where plans or grants have different characteristics that would make separate disclosure important to understanding them. For example, a company may need to provide separate disclosures for service-based grants versus performance-based grants. A company would not typically need to provide separate disclosure simply because the tax treatment, vesting schedules, or contractual terms of the grants differed. SAB No. 120 indicates that separate disclosure may be necessary for spring-loaded grants. For all stock plans, the company must disclose: The number of shares authorized for issuance under the plan, and the general terms of the options or awards granted under the plan, such as vesting and contractual terms. • The method used for measuring the fair value of options and awards granted during each year presented in the company's income statement. • A description of the assumptions (volatility, expected term, dividend yield, and interest rate) used for valuation purposes for all options and awards granted during each year presented in the company's income statement, as well as the method used to determine expected volatility and the expected term of options. Where multiple values are used for any inputs, the range of values used should be disclosed. • Use of the simplified method to estimate the expected term of any options, the reason this method is used, the types of options it is 136 ACCOUNTING FOR EQUITY COMPENSATION used for (if it is not used for all options), and the periods it is used for (if it is not used for all periods presented). • Use of the practical expedient (adopted under ASU 2016-09) to determine the expected term of any option grants. • How any discounts to fair value were determined for post-vesting sale restrictions (if applicable). • Use of the practical expedient (adopted under ASU 2021-07) to determine the fair market value of the stock underlying equity awards. • For spring-loaded grants, how the company determines when an adjustment to fair value is necessary for the grants, how the amount of the adjustment is determined, and any significant assumptions used to determine the adjustment. • The weighted average grant date fair value of all options and awards granted during each year presented in the company's income statement. • The intrinsic value of options exercised and fair value of awards vesting during each year presented in the company's income statement. • Total compensation expense recognized for stock compensation in each year presented in the company's income statement. • The terms of any significant modifications made to grants during any year presented in the income statement, including the number of award holders affected and the total incremental compensation expense resulting from the modification. • The total remaining unamortized expense for stock compensation as of the date of the company's most recent balance sheet. • The amount of cash used to settle stock compensation. • The method used to account for forfeitures (i.e., whether the company applies an estimated forfeiture rate or accounts for forfeitures only as they occur). For stock options, stock appreciation rights, and share units, the company must disclose: Chapter 14: Disclosures 137 • For the most recent year presented in the company's income statement, the number and weighted average exercise prices (or conversion ratios) of shares outstanding at the beginning and end of the year, exercisable or convertible during the year, granted during the year, exercised or converted during the year, and forfeited or expired during the year. • For grants that are fully vested or expected to vest as of the date of the company's most recent balance sheet, the number of shares, weighted average exercise price (or conversion ratio), aggregate intrinsic value, and weighted average remaining contractual term of shares outstanding and also those currently exercisable. • The amount of cash received and the tax benefit realized from option exercises during the most recent year presented in the income statement. • The source of shares issued for option exercises (i.e., treasury shares or authorized but unissued shares) and the company's repurchase policy, if any. Where the company has a repurchase policy, the company should also disclose the number of shares expected to be repurchased over the subsequent annual period. For restricted stock awards: • For the most recent year presented in the company's income statement, the company must report the number and weighted average grant date fair value of shares unvested at the beginning and end of the year, shares granted during the year, shares vested during the year, and shares forfeited during the year.

Market Condition Awards - Expense recognition for changes in service period

A market condition is a goal that is tied to a stock price, either on an absolute basis or on a relative basis against comparable companies. Awards with market conditions reflect the probability of achieving the performance targets within a valuation model. Compensation cost is recognized for an award with a market condition provided the requisite service period is completed, as discussed in subsection 10.8, regardless of the ultimate payout of the performance award. See Exhibit 10-1 for an example of a market condition.

Measurement, Valuation, and Recognition - Spring Loaded Awards

A spring-loaded grant is one that is granted in advance of a public announcement that the company expects will cause its stock price to increase. Examples of such announcements might include, but are not limited to, earnings results that exceed the company's forecast, plans to acquire another company, a change in corporate structure or capitalization, a material new contract or customer acquisition, or a government approval necessary to the company's business. By granting options or awards in advance of such announcements, the grant occurs before the company's stock price increases in response to the announcement. This would result in a lower grant date fair value than if the company waited until after the announcement to complete the grant and, in the case of stock options, would result in a lower exercise price. Staff Accounting Bulletin No. 120, issued by the SEC in November 2021, instructs public companies that issue grants in contemplation of or shortly before the release of material nonpublic information to consider whether adjustments to the current fair market value of the company's stock or the expected volatility assumption are necessary for purposes of determining the fair value of the grants. SAB No. 120 notes that non-routine grants merit particular scrutiny. Thus, when public companies issue grants in anticipation of the release of public announcements that are expected to cause their stock price to appreciate, it may be necessary for companies to estimate the effect of the planned announcements and incorporate this into the grants' fair values for ASC 718 purposes. This is especially a concern if the grants are not made in accordance with an established grant pattern.

ESPP - Treatment of Forfeitures

A termination is considered a pre-vesting forfeiture. Previously recognized expense for the purchase is reversed and no further expense is recognized, similar to a stock option that is forfeited prior to vesting.

ESPP - Treatment of Withdrawals

A withdrawal occurs when an employee decreases his or her contribution to $0 (or 0%) and obtains a refund of any amounts previously contributed during the purchase period. When a withdrawal occurs, the grant date expense associated with the shares is not reversed. The withdrawal is ignored for accounting purposes, which is similar to the accounting treatment of a cancellation of an employee stock option (i.e., the requisite service period has been satisfied and the employee is simply choosing not to "exercise" the "option" to purchase the shares). The treatment of a withdrawal is further complicated when a plan contains a reset or rollover feature. If an employee withdraws prior to a reset or rollover occurring, then no incremental expense associated with the award is recorded since no additional benefit is realized by the employee.

Grants - Measurement Date - general understanding

ASC 718 requires companies to record the fair value of their equity award grants as an expense on their income statements. "Fair value" is defined as the worth of the award itself on the measurement date, with all caveats and requirements (such as the expected amount of time until the option is exercised, any consideration that must be paid for it, etc.). Theoretically speaking, it is what an option or other award would sell for if there were an open market for it, as there is for options in commodity futures. The fair value of an award is determined on its "measurement date." For awards that settle in stock, the measurement date is generally the grant date. If the award is made in the form of stock options or SARs, the company must use an option-pricing model to determine the grant date fair value. The same is true for ESPP shares, unless they qualify for a safe-harbor exception. In contrast to the treatment of stock-settled grants, the measurement date for cash-settled awards does not occur until the settlement date, meaning the date of exercise, vesting, or expiration. Because the measurement date fair value is not known until the award is settled, the company must remeasure fair value each reporting period by calculating the current fair value of the grant, i.e., using an option-pricing model to estimate the fair value just as with stock-settled awards (for RSUs, the current market value is used for remeasurement). If the company is publicly traded, the current trading price must be used; if private, the company may choose to use either the current value of the underlying stock or its intrinsic value (i.e., the difference between the exercise price of the option or SAR and the current market value of the underlying stock). The measurement date for grants to nonemployees is the same as the measurement date for employee grants.

Modifications - Restructuring/Purchase Business Combination

Accounting Standards Codification Topic 805, Business Combinations (abbreviated here as "ASC 805"), effective for business combinations in which the acquisition date occurs after the beginning of the first annual reporting period beginning on or after December 15, 2008, provides guidance on how to account for options and awards exchanged pursuant to purchase business combinations. ASC 718 (formerly SFAS No. 123(R)) does not provide specific guidance in this area, other than to state that exchanges of grants pursuant to a business combination are accounted for as modifications. Under ASC 805, the fair value of the grants before the conversion/ exchange is determined on the consummation date of the acquisition. The computation of fair value should be based on the market value of the target company's stock and should reflect the impact of the acquisition. For stock options, the fair value is computed using an option pricing model that considers the expected volatility and expected dividend yield of the target company's stock, as well as the options' pre-conversion exercise price and expected term. The valuation can be particularly challenging for stock options, where the impact of the acquisition on the options' expected lives can be difficult to estimate. Some approaches that companies might take to estimate the options' expected lives might be: • Apply the simplified method described in SAB No. 107 (see section 4.3.1), although this can be problematic because the options are unlikely to be at-the-money, which is a requirement under SAB No. 107 to rely on this method as a safe harbor. Companies may still be able to rely on this method, but they should be careful to explore whether other, more appropriate methods of estimating expected term are viable. • Apply the "Computed Expected Life" method described in IRS Revenue Procedure 98-34, which is normally used for valuing options for estate tax purposes. This method involves dividing the weighted average expected term for all options granted during the year by the total number of years in the option's contractual term and then multiplying the resulting by the remaining years in the contractual term. • Analyze peer data for options with similar market-to-strike-price ratios that were exchanged in other business combinations. • Use a more sophisticated pricing model, such as a Monte Carlo simulation or lattice model, to estimate expected term. Once the new fair value has been determined, the portion attributable to past service is considered to be part of the purchase price of the acquisition, and the portion attributable to future service is recognized as compensation expense by the new entity. Thus, the full fair value of vested portions of any grants exchanged/converted during the acquisition is considered part of the purchase price. For the unvested portions of the grants, a pro-rata allocation of the fair value is applied to determine what portion of the fair value is treated as part of the purchase price and what portion is compensation expense. To determine what portion of the fair value is attributed to past service (and thus is treated as part of the purchase price), it is first necessary to determine the total service period, which will be the period from when the options or awards were granted until their ultimate vesting date after consummation of the acquisition. The percentage of the fair value that is allocated to the purchase price is the portion of the total service period that elapsed before the consummation of the acquisition, divided by the total service period, or, if the vesting requirements were shortened during the conversion/exchange, the original service period. The portion of the grants' fair value that is attributable to future service (i.e., is not treated as part of the purchase price) is treated as compensation expense and is recognized by the new entity over the grants' remaining service period. In addition, the fair value of the grants (both vested and unvested) should be recomputed just after the acquisition consummation and compared to the fair value computed for the awards just before the acquisition. The post-acquisition fair value will be based on the market value (and, for stock options, the expected volatility and dividend yield) of the acquirer's stock. The post-acquisition valuation for stock options should also consider the post-conversion exercise price and expected term (which, again, may be difficult to estimate). In many cases, there will be little or no difference in the fair value of the award before and after the acquisition, but any increase in fair value of the awards results in additional incremental compensation cost. For vested awards, the incremental cost is recognized immediately; for unvested awards, it is recognized over the remaining service period. All of the amounts discussed above—the portion of the grant fair value included in the purchase price, the portion treated as compensation expense, and any incremental expense—are adjusted for expected forfeitures and, on an ongoing basis, are adjusted for changes in forfeiture estimates and actual outcome. Note, however, that no adjustments are made to the amounts included in the purchase price; any changes to these amounts as a result of varying forfeiture rates are recorded in compensation expense. The treatment of options and awards exchanged in a business combination is one of the most complex aspects of accounting for stock compensation and may be affected by factors that are outside the scope of this book, such as the structure of the business combination. Rea

International -IFRS 2 - Tax Accounting

Accounting for tax effects is one the most significant areas of difference between IFRS 2 and ASC 718. • Under IFRS 2, tax expense is adjusted and deferred tax assets are recorded based on the current intrinsic value of the options and awards granted. These amounts are adjusted from period to period, as the intrinsic value fluctuates. • Under IFRS 2, any tax benefits in excess of the tax savings estimated based on the expense recorded for options and awards are treated as paid-in capital, whereas under ASC 718, excess tax benefits reduce recorded tax expense. • Tax shortfalls, however, are treated the same under both standards: both require the shortfall to be recorded as additional tax expense.

Performance Condition Awards - Vesting contingent on IPO/CIC

Another somewhat common practice among privately held companies is to grant options or awards in which vesting is contingent on the company's IPO (or acquisition by another company). Oftentimes, the awards are subject to both service-based vesting conditions in addition to the IPO/CIC vesting condition. The period over which the service-based conditions are achieved often differs from the period in which the IPO/CIC must be achieved. The service-based conditions are often fulfilled over the three- or four-year period following grant, whereas the grants might allow for up to ten years for the IPO/CIC to be achieved. (This differs from more traditional performance awards in which vesting is contingent on operational or market conditions and in which the service and performance conditions are typically fulfilled over the same time period. As is the case for other types of awards that are subject to nonmarket performance conditions, expense should be recorded only to the extent that the performance condition (i.e., an IPO or CIC) is likely to achieved. But, unlike operational metrics, when the performance metric that vesting is contingent on is an IPO or CIC, the FASB has indicated that the likelihood of the condition being achieved should be considered to be 0% until the IPO or CIC is a certainty. Thus, where vesting in options or awards is conditioned on an IPO or CIC, no expense is recorded for the grants until just before the consummation of the IPO or CIC. Once an IPO becomes certain, expense for the grants that will vest as a result of it is recorded commensurate with the portion of the service-based vesting period that has elapsed. Any expense attributable to service that has already been performed as of the date of the IPO is recorded immediately in full in the period of the IPO. Expense attributable to future service will be recorded in periods after the IPO as the service is performed.

Forfeiture Rate - Changes in estimates - Static Method

Applying estimated forfeiture rates to expense attributed under ASC 718 described here is just one approach that is acceptable under the standard. Other approaches are acceptable as well. The approach described here is commonly referred to as the "static" method. Another common approach that is also generally considered to be acceptable under the standard is referred to as the "dynamic" method. Under the dynamic method, the forfeiture rate applied to each individual award is weighted based on the length of the remaining service period. As the grant nears the end of its service period, the likelihood of vesting is greater, thus the forfeiture rate applied to the grant is lower. Grants that have been forfeited have no likelihood of vesting, so they are removed from the calculation. An advantage to the dynamic method is that where estimates of forfeitures turn out to be inaccurate, this approach is self-correcting as forfeitures occur. Under the static method, companies must carefully monitor forfeitures throughout the service period and adjust the estimated forfeiture rate applied to awards accordingly. Otherwise, where actual outcome differs materially from initial expectations, a large adjustment will have to be recorded when the service period ends. Under the dynamic method, however, as forfeitures occur, the forfeited awards are removed from the expense attribution; likewise, the expense for awards that have not been forfeited is gradually increased as the service period progresses and the likelihood that the awards will vest increases. This relieves some of the burden for monitoring forfeitures throughout the service period and can result on lower fluctuations in expense from period to period.

Measurement of Compensation Cost - RSAs/RSUs

Calculating the fair value of restricted stock and restricted stock units with time-based vesting is easier than calculating the fair value of options. The fair value is the difference between the FMV at the measurement date (usually date of grant) and the amount paid for the stock (usually $0). The fair value must be decreased if dividends are paid on the underlying stock, but will not be paid on unvested awards. The fair value of the award is expensed over the service period. In many cases, the amount of the expense to be accrued should be reduced by the forfeiture rates in order to reflect grants that are not expected to vest during the accrual period. If the restricted stock is offered to employees at a price equal to the fair market value on the date of grant, the company does not recognize any expense for the arrangement. Where a company grants restricted stock purchase arrangements with a purchase price less than the fair market value of the company's stock on the date of grant, or awards the stock at no cost to the recipients, compensation expense results under ASC 718. This expense must be amortized, or "accrued," over the service period for the arrangement. The service period is generally the vesting period for the arrangement, but other factors, such as automatic acceleration of vesting upon retirement, may have an impact on the determination of the service period. Where the arrangement is subject to vesting contingent on performance goals or price targets, the service period is derived based on the time period in which the goals or targets are expected to be achieved.

SAB 107 - Valuations - Use of Peer Volatility

Companies are also permitted to consider peer company data when estimating their expected volatility. Companies that have no or little trading history (such as private and newly public companies) may have little choice but to rely on peer data; other companies may find peer data helpful as well. When relying on peer data, ASC 718 requires identification of specific companies; it is not permissible for public companies (even newly public companies) to rely on an index. ASC 718 technically permits private companies to rely on an index if they cannot identify peer companies but even this is generally prohibited in practice (see section 13.1 of this book). Examples of situations where peer company data may be helpful for estimating expected volatility include the following: • Companies that have been public for a shorter period of time than the expected terms of their options. • Companies that have recently experienced a significant change in organizational structure (e.g., a major acquisition or spin-off) or expect to experience such a change in the future. • Companies that have recently experienced a significant business disruption that affected their stock price, (e.g., bankruptcy or a major corporate scandal). • Companies that have recently begun paying dividends or ceased paying dividends. • Companies that feel that their historical stock price patterns are not indicative of how their stock price will fluctuate in the future and are able to support this position to the satisfaction of their auditors.

Tax Accounting - Non-Qualified Arrangements - Shortfalls

Conversely, where the actual tax savings is less than the previously recorded benefit (a "tax shortfall"), tax expense is increased. The difference between the DTA and the actual tax benefit is recorded as additional tax expense on the company's income statement. Generally, the expiration of nonqualified options or SARs result in shortfalls since the participant recognizes no income and therefore the company receives no tax deduction and recognizes no tax benefit. Thus, at the time of expiration, the company must reverse the DTA and record a corresponding increase to tax expense.

International -IFRS 2 - Liability treatment for share withholding

Currently, under IFRS 2, shares tendered back to the company to cover tax withholding must be limited to the minimally required tax withholding to avoid liability treatment. Where shares are tendered in excess of the minimally required tax withholding, only the shares tendered to cover the taxes are treated as a liability; the rest of the award can still receive equity treatment.

Valuation Factors - Required Factors

Exercise Price, Underlying value of stock, Expected Term, Expected Dividend Yield, Risk free interest rate, Expected Volatility

SAB 107 - Valuations - Use of Historical Volatility

Expected volatility is often based on historical volatility, but it should be adjusted if the historical data is not indicative of future expectations. While an analysis of historical volatility is usually the first step in determining expected volatility, there are a number of other factors to consider: • The length of the historical period used to calculate historical volatility in relation to the term (or expected term) of the options being valued. • Significant corporate or market events that occurred during the historical period that may have influenced volatility and are not likely to occur in the future. • The maturity and structure of the company during the historical period. • Market conditions during the historical period. Generally, when using the Black-Scholes model to value equity awards, historical volatility is calculated over a period that is commensurate with the expected term of the options being valued. When using a lattice model, the historical period should be commensurate with the contractual term of the options. In both cases, if a company's public trading history is insufficient, it may be necessary to also incorporate alternative methods into the expected volatility assumption, such as looking to peer company volatilities or implied volatility. SAB 107 permits the expected volatility assumption to be based on historical volatility computed over longer periods if the company reasonably believes that this longer period will improve the volatility estimate. If historical volatility is calculated over an extended period, it may be attractive to give more weight to the stock's volatility in recent years (especially if volatility is lower in these years), since the company may feel that these years may be more reflective of future conditions (for both the company and the market). Unfortunately, in SAB No. 107, the SEC discourages this practice. Therefore, companies that believe their long-term historical volatility is not indicative of their future volatility may be forced to find other support for adjusting this assumption. SAB No. 107 permits public companies to rely exclusively on historical volatility when estimating expected volatility if the methodology is consistently applied and the following conditions are met: • The company has no reason to believe that the expected volatility of its stock over the expected term of the option is likely to differ from its past volatility. Examples of circumstances that could give cause to believe future stock price volatility will differ from past volatility include a material change in the company's business model or the introduction of an important new product. • Historical volatility is calculated using a simple average (as opposed to a calculation that places greater weight on certain time periods). • Historical volatility is calculated over a sequential period that is at least equal to the expected term of the options being valued. • Sufficient price observations are used and measured at a consistent point throughout the historical period. Price observations should be at least monthly and should be more frequent for periods of less than three years.

Forfeiture Rate - Adjusting to actual outcome

For Market Based awards - Because the initial valuation is adjusted for the market conditions, there is no reversal of expense later if the conditions are not achieved (provided the requisite services are rendered). For options and awards that are subject to non-market performance conditions, the valuation is computed without regard to the performance conditions, and expense is recognized only for the portion of the option or award that vests. Companies are required to estimate the likelihood that the performance conditions will be achieved and adjust the expense recorded for the grants commensurately. As expectations as to vesting change, the expense recorded for the grants should be adjusted, and ultimately this expense recorded should be trued up to the actual vesting outcome. Grants that are subject to market conditions are almost always also subject to service conditions and are sometimes also subject to non-market performance conditions. Although expense is recognized for the grant even where the market conditions are not fulfilled, expense is not recognized for any portion of the grant forfeited due to failure to meet the service or non-market performance conditions. where vesting in performance-based options and awards is contingent on non-market related goals, companies are required to estimate the likelihood that the goals will be achieved and must record expense based on the expected vesting outcome. It is not permissible to simply account for performance-based forfeitures as they occur. As the company's expectations change, the expense recorded for the award must be adjusted commensurately. Just as for adjustments to forfeiture expectations for service-based awards, the change in expectations is recorded with a cumulative adjustment in the period that the change occurs. In other words, the adjustment is computed as if the company had applied the new expectation all long, beginning when the awards were granted.

Forfeiture Rate - Initial Estimate

For grants in which vesting is contingent on service or performance conditions, expense is recognized only for arrangements that actually vest. Because expense is recognized only if the vesting conditions are fulfilled, the initial fair value of the grant is determined without regard to these conditions. Moreover, note that expense is not reversed in any circumstances for arrangements after vesting, even when the arrangements subsequently expire unexercised. Likewise, expense cannot be reversed when options and awards are cancelled at the request of or with consent of the award holder. Once an option or award is granted, only forfeiture due to failure to meeting vesting conditions can prevent recognition of expense for it.

SAB 107 - Valuations - Simplified Expected Term formula

For public companies that have insufficient historical data or that feel that historical exercise patterns are not reflective of current grants (for example, where the vesting, expiration, or other terms of new grants differ materially from prior grants), SAB No. 107 permits companies to assume the expected term is the average of the vesting period and the contractual term of the option (referred to as the "simplified method"). For example, if an option is subject to four-year cliff vesting and a contractual term of ten years, the company could assume an expected term of seven years. This formula can only be relied on for "plain vanilla" options, which the bulletin defines as service-based, at-the-money options where, upon termination, unvested shares are forfeited and vested shares are exercisable for a short period. SAB No. 110, issued on December 21, 2007, stipulates that companies may only rely on the simplified method in the absence of sufficient exercise history, i.e., where the company lacks historical exercise data; the company has historical exercise data but has substantially changed the terms of its option grants so that the historical data is not relevant to the options currently being valued; or the company has historical exercise data but has experienced structural changes in its business that render the historical data irrelevant to the option grants currently being valued. SAB No. 110 further indicates that the SEC staff expects data on exercise patterns to eventually become widely available and that once such data is available, the staff expects that this simplified formula will no longer be used. The simplified method is available only to public companies, but ASU 2016-09 amended ASC 718 to include a practical expedient that private companies may rely on to determine expected term in certain circumstances. The practical expedient is discussed in chapter 13 of this book.

International -IFRS 2 - Country specific valuation inputs and forfeiture assumptions

For valuation purposes under ASC 718, most companies apply one set of assumptions to all options granted to rank-and-file employees. Under IFRS 2, it is likely that companies will have to tailor valuation assumptions to each country where their employees have received options. This is most relevant to the expected term assumption; under IFRS 2, it may be necessary to evaluate exercise behavior by country and vary the expected term assumption based on this analysis. IFRS 2, it may be necessary to evaluate termination patterns by country and to apply different forfeiture assumptions to the employees of each country based on that analysis. In addition, IFRS 2 does not allow companies to adjust for forfeitures only as they occur.

International -IFRS 2 - Non-compensatory plans

IFRS 2 considers all employee stock purchase plans to be compensatory.

International -IFRS 2 - Required attribution method for awards with graded vesting

IFRS 2 requires expense to be recorded using the accelerated attribution method for grants with graded vesting.

SAB 107 - Valuations - Use of Implied Volatility

If options on the company's stock are actively traded, it may be illuminating to compute the stock's implied volatility using the values of the traded options. When the trading price of an option is known, along with the other inputs used to determine the value, the Black-Scholes model can then be applied to determine the volatility assumption. This is referred to as "implied volatility" and it is considered to reflect how the stock is perceived in the marketplace. Implied volatility, however, can, in itself, be very volatile, so companies may want to avoid relying on it too heavily. When relying on implied volatility, companies should consider the trading volume in their stock and options; more actively traded securities are likely to be more relevant. It is also preferable to look to options that are traded as close to the grant date as possible and that have a similar exercise price and remaining term. Tradable options often have much shorter terms than employee stock options; SAB No. 107 suggests looking to traded options that have terms of six months or longer, and, where the terms of the traded options are less than a year, not relying solely on implied volatility to estimate expected volatility. SAB No. 107 permits exclusive reliance on implied volatility if the methodology is consistently applied and the following conditions are met: • The option-pricing model used to value options is based upon a constant volatility assumption. The Black-Scholes model meets this condition. Pricing models that incorporate a range of volatility assumptions do not meet this condition. • The implied volatility is calculated using options that are actively traded. • The market prices of the traded options and the company's stock are measured at approximately the same time, on a date that is reasonably close to the grant date of the options being valued. • The traded options have prices that are near to both the current value of the stock and the exercise prices of the options being valued. • The traded options have a term of at least one year.

Modifications - Awards exchanged for cash

If the award holder receives a cash payment in exchange for the cancellation or settlement, the amount of the payment that exceeds the award's current fair value is recorded as additional compensation expense in the period the cancellation/settlement occurs.

ASC 260 - Diluted EPS - Stock Options and SARs

It is assumed that the company will use the proceeds it would realize for the assumed exercises/issuances/releases to repurchase its own stock. This assumption applies even where the company does not have such a repurchase program in place. Thus, in step 3, the total proceeds are determined, and the number of shares the company could repurchase using these proceeds is computed. It is assumed that the repurchase price will be the average market value of the stock over the reporting period. The transaction proceeds assumed in above can include up to two amounts: • the exercise price of the option or any amount paid for the issued stock, and • the average unrecognized expense for the grant over the reporting period (excluding the effect of estimated forfeitures). Example: Assume an option to purchase 10,000 shares at $10 is outstanding during a period when the average market value is $25 per share. The total exercise price is $100,000, which, at the average market value for the period, would enable the company to repurchase 4,000 shares ($100,000 divided by $25), resulting in 6,000 net shares issued on the hypothetical exercise. e average unamortized expense for the grant is considered an additional source of proceeds that the company could use to repurchase its own stock. The unamortized expense represents the value of services the company will receive from the grant recipient in the future. These services will produce revenue that would increase the company's earnings and make the grant less dilutive. Because it is not reasonable to estimate what the future revenue might be, the unamortized expense is treated as a form of transaction proceeds. Let us return to our original example of a nonqualified stock option to purchase 10,000 shares at $10 per share, outstanding during a period when the average market value is $25 per share. Assume that the unamortized expense for the option is $30,000 at the beginning of the period for which we are computing EPS and is $20,000 at the end of the period, resulting in an average unamortized expense for the option during this period of $25,000. (The average unamortized expense for the option is calculated by combining the beginning and ending unamortized expense and dividing by two.) This increases the number of shares that the company can repurchase by 1,000, further reducing the number of shares included in the denominator from 6,000 to 5,000 (10,000 shares outstanding less 4,000 shares repurchased using the option price and 1,000 shares repurchased using the average unamortized expense). A fundamental premise in ASC 260 is that options are dilutive—in other words, they decrease earnings per share. Options that would have the effect of increasing earnings per share are considered antidilutive and are excluded from the calculation in their entirety. For example, if the average stock price for the reporting period in the $10 option example were $8 per share, the number of shares the company could repurchase with the exercise proceeds would be at least 12,500 shares ($100,000 exercise price divided by $8). Since the option itself is for only 10,000 shares, including this option would decrease the number of shares in the denominator for diluted EPS purposes. Thus, the option is considered antidilutive and is excluded from the denominator for diluted EPS (in this case, it is, in any event, unrealistic to assume exercise of an underwater option). As is the case with other types of stock-based awards, SARs are excluded from basic earnings per share. Where SARs can be settled in stock only, however, they are included in diluted earnings per share using the treasury stock method in the same manner as nonqualified stock options. The SARs are assumed to be exercised at the average market value for the period, and the net shares representing the gain upon exercise are assumed to be issued. The number of shares issued is reduced by the number of shares the company can buy back using the average unamortized expense for the SAR. The result, if dilutive, is then added to the denominator for the diluted EPS calculation. See chapter 10 for more information. Where SARs can be settled in cash only, they are excluded from diluted earnings per share as well as basic earnings per share. Where SARs can be settled in cash or stock, the presumption generally is that the SARs will be settled wholly in stock and they are included in diluted earnings per share in the manner described above (and in chapter 10), provided that their inclusion produces a more dilutive result. However, where settlement in cash or stock is at the company's discretion (rather than the award holder's discretion) and the company can demonstrate through historical experience or stated policy that the SARs will be settled in cash, they can be excluded from diluted earnings per share as well as basic earnings per share.

Grants - Measurement Date - Performance Awards

It is not unusual for performance-based options and awards to be granted after the start of their respective performance measurement periods. In many cases, the beginning of the performance period aligns with the start of the company's fiscal year, but the option or award is not granted until after the performance period has commenced. For example, a company with a calendar-year fiscal year might wait until its board meets in February or March to grant the current year's performance awards, but performance might be measured from the start of the fiscal year in which the awards are granted. Similar to awards granted to newly hired employees in which commencement of vesting is tied to the employee's hire date, this does not cause the service period to begin before the date the award is granted. The service inception date will be the date of grant. For purposes of expense measurement, the fair value of the award will be determined based on the conditions that exist at the time the grant date occurs, not as of the start of the period over which performance is measured. For example, assume that on March 1, 20X6, when the fair market value is $68 per share, a company grants a performance share award for 10,000 shares, for which performance will be measured over the period beginning on January 1, 20X6, through December 31, 20X9. The fair market value on January 1, 20X9, was $62 per share. Assuming all other conditions have been met to establish March 1, 20X6, as the grant date, the fair value of the award will be determined as of this date. The fair value of the award is equal to the $68 fair market value on March 1, resulting in total expense of $680,000, which will be recognized from March 1, 20X6, to December 31, 20X9. This will result in recognition of $20,000 of expense per month ($680,000 divided by 34 months in the service period). No expense is recognized during the two months that elapse between the start of the performance measurement period and the grant date.

ESPP - Automatic Rollover and Reset Provisions

Many ESPPs that have multiple purchases within a single offering period include a reset or rollover provision that is triggered when the fair market value has declined during the period. These provisions require that if the fair market value of the stock on the purchase date is less than the fair market value at the beginning of the offering, all employees enrolled in that offering are automatically withdrawn from the plan and immediately reenrolled in a new offering period. Under a reset provision, the employees are reenrolled for only the remainder of the current offering (for example, if the reset mechanism is triggered 6 months into a 24-month offering period, the employees are reenrolled for the remaining 18 months only). Under a rollover provision, the employees are reenrolled in new offering period equal to the length of the original period (for example, if the offering was originally 24 months in length, the employees are reenrolled in a new 24-month offering regardless of when the rollover mechanism is triggered). ASC Section 718-50-55 addresses both reset mechanisms (a "Type D Plan") and rollover mechanisms (a "Type E Plan"), requiring that both be treated as a modification of the original option. To account for the modification, the employer recognizes all of the cost associated with the original offering period but now also recognizes the incremental cost of the new offering period. The incremental cost is equal to the fair value of the new offering less the fair value of the original offering at the time the reset or rollover mechanism was triggered. Example: Assume the same facts as in Example 2, but assume that the fair market value on the first purchase date is $8 per share, triggering a reset provision in the plan. All participants are automatically withdrawn after the first purchase and re-enrolled at $8 per share for the remaining 6 months of the offering. This is viewed as a modification, i.e., a cancellation of the original offering and the start of a new offering. The company must continue to recognize the $655,000 of expense computed for the original offering, but it now must also recognize the incremental expense of the new offering. The incremental expense is computed as in tables 11-5 and 11-6 (assuming 50% volatility, 5% risk-free interest rate, and no dividend yield on the underlying stock). In computing the fair value of the cancelled 12-month offering, since the 6-month purchase was completed before the reset, only the value of the 12-month purchase period is applied against the value of the new offering. The value of the 12-month offering is recomputed based on current conditions, as in table 11-6. The aggregate incremental expense for the new offering is $93,750. This is the fair value of the new offering ($293,750) less the current fair value of the cancelled offering ($200,000). This incremental expense is recognized over the remaining six-month term of the new offering, along with any remaining unamortized expense from the original offering.

ESPP - Non-Qualified Plans

Many companies choose to implement an ESPP that qualifies for preferential tax treatment under Section 423. This increases the company's administrative burden because the plan must be operated in a manner that complies with the requirements specified in Section 423 and also imposes certain limitations on the design of the plan (e.g., eligible participants, minimum purchase price, and length of the offering period). In addition to monitoring ongoing compliance with Section 423, the company is also responsible for tracking sales and other dispositions of stock acquired under the plan and for compliance with the notification requirements of Section 6039 of the Code. Where companies want to implement a plan that provides benefits not permissible under Section 423 or where companies do not want to take on the obligations of complying with Section 423 and related tax codes, they may implement a nonqualified ESPP. Under the tax code, non-Section 423 plans are treated as nonqualified stock options, and any discount at purchase is subject to tax withholding for both income and employment tax purposes. In the case of a broad-based ESPP that does not qualify under Section 423, stock purchased will be treated, for tax purposes, as though it had been acquired under a nonstatutory stock option. As a result, a plan participant will recognize ordinary compensation income for federal income tax purposes at the time of purchase measured by the excess, if any, in the fair market value of the shares at the time of purchase over the purchase price. Subject to the deduction limitation under Code Section 162(m), the company will be entitled to a tax deduction in the amount and at the time that the plan participant recognizes compensation income with respect to shares acquired under the plan. If the participant is also an employee of the company, the compensation income recognized at the time of purchase will be treated as wages and will be subject to tax withholding by the company and reporting (e.g., on Form W-2). Upon a sale of shares by the participant, any difference between the sales price and the purchase price (plus any compensation income recognized with respect to such shares) will be a capital gain or loss and will qualify for long-term capital gain or loss treatment if the shares have been held for more than one year. The company has no reporting or withholding obligations with respect to capital gains and losses. Section 6039 does not apply to ESPPs that are not qualified under Section 423, so the company is not required to file the IRS returns or provide the participant statements described in section 11.4.2 for non-Section 423 ESPPs.

Measurement of Compensation Cost - Non-forfeiture of Dividend payments

Note, however, that where dividends are paid on awards that are ultimately forfeited, the company will recognize compensation expense for the dividends. In this situation, because of the forfeiture, the company will not recognize any expense for the award itself. However, the employee has received compensation in the form of the dividend payment; that compensation should be recognized as an expense. Another way to think of it is that the original award encompassed both the underlying shares and the future dividend stream that would be paid on them; both of these components contributed to the award's fair value. Now that the underlying shares have been forfeited but the employee retains the dividend payments, the company still must recognize expense for the portion of the award that was not forfeited, i.e., the dividend payments. Thus, the portion of the award's fair value that is attributable to the dividends is recognized as compensation expense. This scenario is much more likely to occur with dividends that are paid on a current basis. For example, assume that on January 1, 2018, a company grants a restricted stock award that cliff vests in four years. The company pays a dividend to the grantee in 2019, and then the grantee terminates in 2020, forfeiting the award. In 2019, when the dividend is paid, it is charged to retained earnings. But in 2020, when the award is forfeited, unless the company makes the employee pay back the dividend (highly unlikely), the company will have to recognize compensation expense equal to the amount of the dividend. Where the company applies an estimated forfeiture rate to expense recorded for awards under ASC 718, the company would have to estimate forfeitures up front and record expense for dividend payments based on the estimate, truing up for actual outcome. Or rather, the "haircut" that the company applies to its overall expense for estimated forfeitures is reduced by the amount of the dividends that are expected to be paid out on awards that ultimately will be forfeited. This is less likely to be a concern with dividends that are paid on a deferred basis because they are typically subject to forfeiture if the vesting conditions of the underlying award are not met. Where performance-based awards are eligible for dividends before vesting, the dividend payments should be subject to the same performance conditions as the underlying award. If any portion of a performance award is forfeited and the dividends accrued on the award are not commensurately adjusted for the forfeiture, this results in a situation in which dividends have been paid on an award that was forfeited, causing the company to recognize expense for the dividends, as described above. In addition to the expense considerations, where dividends are paid on unvested awards and the dividends are not subject to forfeiture, the company is required to use the two-class method when reporting earnings per share. The two-class method is typically used by companies with multiple classes of common stock or with other securities that participate in dividends paid to common stockholders. The method uses a formula to allocate earnings (the numerator of the EPS equation) to each security. Thus separate EPS calculations would be required for the company's unvested awards vs. the rest of its common stock. A full discussion of the two-class method of reporting EPS is beyond the scope of this chapter. Where employees receive dividends on unvested restricted stock arrangements that are not subject to a Section 83(b) election, as mentioned earlier, the dividend is treated as compensation income. Consequently, the company recognizes a tax deduction equal to the amount of income reported for the dividend; the tax savings attributable to this deduction are recorded to tax expense.

Measurement of Compensation Cost - Cheap Stock issues

One complexity faced by privately held companies is determining the fair market value of their stock. Public companies can readily determine the value of their stock based on current trading prices in the public securities markets (such as the NYSE or Nasdaq); private company stock is generally not bought and sold on a regular basis, and thus these companies cannot look to trading prices to establish the value of their stock. Nevertheless, for any private company that wishes to offer stock compensation, establishing the stock's value is critical for tax and securities law purposes as well as accounting purposes. For private companies that offer restricted stock, the fair market value of the stock is often the only measure of expense for the awards. For stock options and stock appreciation rights, the fair market value of the underlying stock is a crucial component of the fair value computation. Generally it will fall to the private company's board of directors to determine the fair market value of the company's stock. Due to requirements in the Internal Revenue Code (particularly Sections 422 and 409A, which are not related to the accounting treatment of the options and awards and are beyond the scope of this book), the board should employ an independent third-party appraiser to assist in determining the fair market value of the company's stock. The fair market value determined for tax purposes is generally relied on for accounting purposes as well. At a minimum, the fair market value of the company's stock should be reviewed annually, and it may be necessary to review it more frequently if the company is offering stock to outside investors or is preparing for a public offering or sale of the company. The value may be based on a number of business factors, including earnings, assets, revenue, and/or book value. Where stock is being sold to outside investors, the selling prices should be considered in determining the value of the stock offered to employees and other service providers (note, however, that stock sold to outside investors is often of a different class, and therefore has a different value, than the stock offered to employees and others). Volatility in the public markets may also necessitate more frequent stock valuations for private companies in the affected industries. For example, a significant decline in price for all public companies within an industry may be cause for the boards of private companies in the same industry to review their stock valuations. When a company completes an initial public offering, the SEC will typically review the fair market values set by the board of directors in the year or two before the offering. If the SEC determines that these values were less than what it believes was the fair market value of the stock at that time (which is often the case), the company will have to recognize additional compensation expense for any options or awards granted during this time. For restricted stock, the additional expense will be equal to the difference between the value set by the board and the value determined by the SEC. For stock options and stock appreciation rights (where expense is based on fair value either because the right will be settled in stock or because the company has elected the fair value method for cash-settled rights), the expense will be the increase in fair value resulting from the SEC's determination of the stock's value. The additional expense resulting from the SEC's determination of the stock's fair market value is often referred to as a "cheap stock" expense. It is not clear that ASU 2021-07 will alleviate any of the cheap stock concerns resulting from a company's IPO.

ASC 260 - Diluted EPS - Awards Outstanding for Part or a Period Only

Options and awards included in diluted earnings per share must be weighted for the length of time they are outstanding during the period. Options and awards that were granted before the start of the period and that are still outstanding at the end of the period are weighted at 100%. All other grants are weighted at a lesser percentage.

Valuation Models - Lattice Model

Other option-pricing models that also incorporate the required inputs include lattice models, sometimes called binomial or trinomial models. These models employ a statistical technique that creates a tree of possible outcomes. For example, in a binomial model, two possibilities are projected for each possible occurrence (for example, the stock price may go up or down). The fair value is then arrived at by considering all of the possibilities, giving a greater weight to the more probable outcomes. Lattice models can also be constructed to consider more data about a grant, such as the vesting schedule, closed trading windows, and the probability that the participant will terminate after vesting, thereby reducing the allowable time to exercise, the expected term, and ultimately the fair value of the grant. Unlike the Black-Scholes option-pricing model, there is no single, standard lattice model. The models are usually created to suit the unique needs of the plan or instrument. Therefore, they are also generally more difficult to audit. In addition, their use will not always result in a lower fair value for the award.

ASC 260 - Diluted EPS - Performance Awards

Performance-based options and awards, both market and non-market, are included as common equivalents in the denominator for diluted EPS purposes only to the extent that the awards would be earned as of the end of the period for which EPS is computed. For example, if performance as of the end of the period is sufficient to secure a threshold-level payout, the awards are included in diluted EPS at their threshold payout level. Where the threshold level of performance has not been achieved by the end of the EPS period, the awards are not included in the diluted EPS calculation (even if the company expects that performance will eventually be sufficient to secure a payout). Performance awards are often considered a contingency in applying the guidance in ASC Topic 260 - Earnings per Share. At the end of each reporting period, the Company is required to measure the quantity of awards that would have been paid out if the performance period had ended during the reporting period. The Company applies the Treasury Stock method to the shares considered issuable based on that measurement as long as the awards are not participating securities. 10.13.2. A company may need to calculate a different quantity of awards expected to vest under ASC Topic 260 than what is used for recognition of compensation expense under ASC Topic 718. For example, a company issues 100 PSUs that vest when annual revenues exceed $10,000,000. Even though the Company is recognizing compensation expense at target for ASC Topic 718 (which represents what the Company ultimately expects to vest), under the contingent share provisions of Topic 260, the incremental awards would not be included until the Company revenue exceeds $10,000,000 (which represents what would vest if the performance period ended today).

ESPP - Share Shortfall

Predicting the number of shares that will be purchased can be challenging due to changes in contribution rates, compensation increases, purchase price, and number of participants. Safeguards should be put in place to identify when the maximum number of shares will be reached. Develop processes for dealing with insufficient shares. This is extremely important during periods of declining stock price for both qualified and nonqualified plans. The most common method of dealing with share shortfalls is reducing the shares purchased on a pro-rata basis. Share limits in a plan lower the fair value of the award. As the price of a stock declines, share limits are more likely to limit the number of shares an employee may purchase. The lower the share limit as compared to the price of the award, the more likely the share limit will be reached during a period. In situations where employees are likely to reach the share limit during a period, a more sophisticated modeling technique like a Monte Carlo simulation may be necessary to value the put option component. This type of modeling is required to consider the various stock price thresholds where employees could reach the share limit. The put option fair value is reduced based on the probabilities of reaching those stock price thresholds. Although not technically correct, some companies in lieu of using a Monte Carlo simulation, continue to use a Black-Scholes valuation model and adjust estimated withholdings to reflect the effect of a potential decrease in share price on the share limit. The difference in values generated by each model may be immaterial.

Liability Treatment - Repurchase Obligations

Shares that are subject to a repurchase obligation on the part of the company are subject to liability treatment when the repurchase provision (1) compels the company to deliver cash or other assets in exchange for the shares and (2) enables award holders to avoid bearing the risks and rewards associated with stock ownership (or if it is probable that the company would prevent award holders from bearing these risks and rewards) for a reasonable period of time after the grant has vested and the underlying shares are issued. For this purpose, "a reasonable period" is considered to be six months; thus, where the repurchase will not occur for at least six months after the grant is vested and exercised, equity treatment will apply. A repurchase feature that is triggered only upon occurrence of an event outside the control of the award holder (such as an IPO or a change in control) does not trigger liability treatment until the event becomes probable of occurring. The standard makes an exception for repurchases that are solely for the purpose of financing tax payments due upon settlement of grant. Here, equity treatment continues to apply, provided that certain conditions are met. See chapter 7 for more information. Liability treatment does not apply when shares are tendered to the company to cover the cost of stock (e.g., to pay for an option exercise) because the company issues its own equity, rather than cash or other assets, in exchange for the tendered shares.

Measurement of Compensation Cost - Stock options and Stock-settled SARs

Stock-settled appreciation rights and restricted stock awards will generally be considered equity awards for purposes of ASC 718. As noted in table 6-1, compensation expense for an equity award is based on the award's grant date fair value. Compensation expense is not subsequently adjusted for changes in stock price. Additionally, compensation expense is not adjusted for vested SARs that expire without being exercised. The fair value of a SAR will be estimated using an option-pricing model as if the award were a stock option. The fair value of a share of restricted stock is based on the price of the underlying share. For purposes of ASC 718, the fair value of a share of restricted stock is established as if the share were vested on the date of grant. Restrictions that lapse once the share has vested, such as restrictions on transferability during the vesting period, may not be considered when determining the fair value of the award for purposes of ASC 718. Restrictions that remain after the share has vested, such as a requirement that vested shares be held for a minimum period of time before being sold, may be considered when determining the fair value of an award of equity-based compensation. The aggregate grant date fair value of an equity award will be recorded as compensation expense over the award's service period. If the award is subject only to a service condition (i.e., plain-vanilla time vesting), compensation expense can be accrued on either a straight-line basis or separately for each tranche of the award as if each tranche were a separate award (i.e., tranche-specific vesting). Compensation expense for an award that is subject to any vesting conditions other than, or in addition to, time vesting must be recorded on a tranche-specific basis. is subject only to a service condition (i.e., plain-vanilla time vesting), compensation expense can be accrued on either a straight-line basis or separately for each tranche of the award as if each tranche were a separate award (i.e., tranche-specific vesting). Compensation expense for an award that is subject to any vesting conditions other than, or in addition to, time vesting must be recorded on a tranche-specific basis.

Valuation Models - Black-Scholes

The Black-Scholes model was developed to value exchange-traded stock options,4 which are significantly different than stock options granted to service providers. Options as a form of compensation typically have much longer terms, are subject to vesting, and can be (and usually are) exercised before expiration. As a result, Black-Scholes has been criticized as an imperfect method of valuing them. Despite these objections, Black-Scholes continues to be the most used way of valuing compensatory stock options and SARs. Under the Black-Scholes model, the expected term of an option or SAR is the length of time the grant is expected to be outstanding. Since most optionees exercise their options long before the options are due to expire (or leave the company, causing their options to cancel if not exercised), this is generally shorter than the contractual term of the grant. As described above, expected term is not an input to lattice models. Instead, these models estimate when exercise is likely to occur based on the suboptimal exercise factor and expected termination rates.

ESPP - Increases in Contribution Rates

The Plan may allow employees to change their contribution rates, suspend contributions for a specified time, or withdraw from the Plan prior to the purchase date. Unlimited changes to contribution rates may be allowed during an offering period or a company can allow decreases but not increases or limit each employee to a specific number of changes. For administrative ease, allow sufficient time for administrative handling of Plan withdrawals (e.g., prohibit withdrawals in the two weeks prior to the end of the offering period to allow sufficient time to process them before the purchase date). Notify Financial Reporting about any contribution rate changes since contribution increases will increase the expense recognized. This includes changes in contribution amounts due to changes in pay (salary, bonuses, etc.).

Performance Condition Awards - Expense recognition for changes in service period

The accounting for options and SARs that vest based on the achievement of any kind of performance target is similar to the accounting for those with time-based vesting. However, there are some key differences, one of which is that the expense must be recognized individually for each vesting tranche using or accelerated amortization. Straight-line recognition is not permitted. With performance-based awards, meaning grants that have performance targets not related to stock price, the recognition of expense is based on the likelihood that the goal will be achieved. For example, if the performance-based award is likely to pay out 80% of the underlying shares, only 80% of the fair value would be recognized and a cumulative adjustment made. If, during the next quarter, the best estimate of likely payout rises to 90%, then 90% of the fair value would be recognized and an adjustment to cumulative expense booked in the period the estimate changes. Although the grant date fair value of the award does not change, the expense recognized from period to period may vary widely. The amount ultimately expensed must be adjusted to reflect actual forfeitures of awards that never vest, whether because of employee terminations or failure to achieve the performance goal. If, instead, the grant is market-based, meaning the performance target is related to stock price or uses metrics that are based on stock price (such as total shareholder return), then the company must calculate the fair value for the award at the grant date via a sophisticated option-pricing model such as a Monte Carlo simulation (a type of lattice-based model) and recognize that fair value over the service period. If a market-based award is forfeited due to a failure to achieve the market-based goal, the expense is not reversed. The option-pricing model itself will have considered when and if the goal was likely to be met and incorporated that estimate into the fair value. The expected term for the award is an output of the option-pricing model rather than an input. However, market-based performance awards frequently have multiple vesting requirements—most commonly a requirement that the optionee remain employed over a vesting period. If the award fails to vest for a reason not tied to the market condition, for example due to a termination of service (failure to meet the requisite service period), then the company is allowed to reverse expense for the forfeited grant. The service period of a performance-vested award may be explicit or may implied by the award's vesting criteria (i.e., the award has an implicit service period). For example, an award of restricted stock that vests on the third anniversary of the grant date if at any point during the three years the company completes the development of a new market offering is subject to a three-year explicit service period. But if the award vests immediately upon the completion of the development of a new product offering, and as of the date of grant management estimates the product development will take 30 months to complete, the award has a 30-month implicit service period. If one year after the date of grant, management estimates the product development will be completed in 12 months, the implicit service period would decrease from 30 months to 24 months. The impact of the change in the length of implicit service period on the expense accrual is recorded in the period of the change and is treated as a change in an estimate. Compensation expense for awards that vest immediately upon the attainment of a market condition that can be attained at any point during the performance period is recorded over the award's derived service period. An example is the expense for an award that will vest immediately if the price of the grantor's stock doubles at any point during a four-year performance period. Long-term incentive awards are sometimes subject to multiple vesting criteria. When vesting of an award is conditioned on satisfying one of two or more conditions, compensation expense is recorded over the shortest of the explicit, implicit, or derived service periods. The guiding principle is that compensation expense (and income) should be recognized on a systematic and rational basis. More specifically, under a performance award plan where compensation is earned based on attaining one or more particular goals over a period of time, compensation should be accrued over the period in relation to the results achieved to date. Also, to the extent results previously estimated or determined to have been achieved prove not to be sustainable, compensation expense is reversed.

ASC 260 - Diluted EPS - Treatment of Unamortized Expense

The average unamortized expense for the grant is considered an additional source of proceeds that the company could use to repurchase its own stock. The unamortized expense represents the value of services the company will receive from the grant recipient in the future. These services will produce revenue that would increase the company's earnings and make the grant less dilutive. Because it is not reasonable to estimate what the future revenue might be, the unamortized expense is treated as a form of transaction proceeds. Let us return to our original example of a nonqualified stock option to purchase 10,000 shares at $10 per share, outstanding during a period when the average market value is $25 per share. Assume that the unamortized expense for the option is $30,000 at the beginning of the period for which we are computing EPS and is $20,000 at the end of the period, resulting in an average unamortized expense for the option during this period of $25,000. (The average unamortized expense for the option is calculated by combining the beginning and ending unamortized expense and dividing by two.) This increases the number of shares that the company can repurchase by 1,000, further reducing the number of shares included in the denominator from 6,000 to 5,000 (10,000 shares outstanding less 4,000 shares repurchased using the option price and 1,000 shares repurchased using the average unamortized expense).

Valuation Factors - Expected Term

The award's expected term. Companies are required to project the amount of time grants will remain outstanding. For options granted to employees, this is generally shorter than the award's contractual term but longer than the vesting period. Note that outside directors are considered to be employees under ASC 718. For options granted to nonemployee consultants, this may be an expected term or the award's contractual term. (This can be determined at the grant level.) Companies that have recently become public generally use the SAB 107 simplified method; private companies use the "practical expedient," which mimics the SAB 107 simplified method.3 Both of these methods calculate expected term using the midway point between vesting and contractual term (expiration). Expected term is an output of lattice models rather than an input.

Valuation Factors - Practical Expedient for Expected Term

The award's expected term. Companies are required to project the amount of time grants will remain outstanding. For options granted to employees, this is generally shorter than the award's contractual term but longer than the vesting period. Note that outside directors are considered to be employees under ASC 718. For options granted to nonemployee consultants, this may be an expected term or the award's contractual term. (This can be determined at the grant level.) Companies that have recently become public generally use the SAB 107 simplified method; private companies use the "practical expedient," which mimics the SAB 107 simplified method.3 Both of these methods calculate expected term using the midway point between vesting and contractual term (expiration). Expected term is an output of lattice models rather than an input. Private companies also typically find it challenging to develop an appropriate expected term assumption, again due to lack of historical activity. ASC 718, as amended by ASU 2016-09, offers a practical expedient to calculated expected term that private companies can use (this practical expedient is not available to public companies, but, as noted in section 4.3.1 of chapter 4, SEC SAB No. 110 offers relief in this area to public companies). The practical expedient is available for options and SARs that meet the following conditions: 1. The option or SAR has an exercise price equal to the fair market value on the date grant (the exercise price cannot be higher or lower than the grant date fair market value). 2. The employee has only a limited time in which to exercise after termination of employment (typically only 30 to 90 days). 3. The employee cannot sell or hedge the option or SAR. 4. The option or SAR does not include a market condition. For options and SARs subject to service-based vesting, the practical expedient is midway between the service period (i.e., the vesting period) and the contractual term of the grant. For example, if an option is subject to four-year cliff vesting and a contractual term of ten years, the company could assume an expected term of seven years. Use of the practical expedient is an entity-wide accounting policy election. Thus, where a private company elects to use this approach, it must be applied to all options (whether granted to be employees or nonemployees) that meet the criteria for its use. The only exception to this is that, on an option-by-option basis, private companies can choose to use the contractual term for purposes of valuing options granted to nonemployees.

Forfeiture Rate - Accounting for forfeitures as they occur

The company can choose to account for forfeitures only as they occur. Under this approach, the full amount of expense calculated for options or awards is recorded, but as grants are forfeited, any previously recorded expense attributable to the forfeited portion of the grant is reversed. Accounting for forfeitures as they occur offers the advantage of simplicity. Companies that do not have the tools or data necessary to effectively estimate expected forfeitures may find this approach less administratively burdensome. Likewise, where the overall expense of a company's stock plan is not significant to its income statement, that company may choose this approach to avoid the burden of estimating forfeitures. Assuming some award holders ultimately forfeit their awards (which is typically the case), a disadvantage of accounting for forfeitures as they occur is that this approach initially overstates the amount of expense companies will recognize for their awards. While this overstatement will eventually be corrected when forfeitures occur, companies may be uncomfortable with the amount of expense initially reported. Applying an expected forfeiture rate to the expense recorded for awards allows companies to report less expense initially. Now let us look at the same example, but with the forfeitures accounted for as they occur. Under this approach, the company simply determines the total percentage of awards that remain outstanding at the end of each fiscal period and calculates the amount of expense that should be recognized thus far for these remaining awards. To determine the expense to recognize in the current period, simply subtract any previously recognized expense from this total.

Valuation Models - Monte Carlo Simulations

The effect of a market condition is included when developing the estimated fair value of the award. The fair value of an award that is subject to a market condition will need to be estimated using a path-dependent valuation model, such as a Monte Carlo simulation.

Tax Accounting - Non-Qualified Arrangements - DTAs

The expense that companies recognize for restricted stock differs from the tax deduction they are entitled to for the arrangements both in terms of timing and the amount of the tax deduction. The expense recognized for the arrangement is equal to the fair value of the arrangement (typically the intrinsic value of the underlying stock) at grant and is recorded over the arrangement's service period, typically the vesting schedule. The company's tax deduction, however, is generally realized only once the arrangement vests (and, in the case of restricted stock units subject to deferral, not until the shares are distributed) and is equal to the intrinsic value of the stock at this time. These differences must be accounted for in the company's financial statements. Assuming that a Section 83(b) election has not been filed for the award, the company records an estimated tax benefit (sometimes referred to as a deferred tax asset) as it recognizes expense for the award. This estimated benefit is always equal to the amount of expense recognized multiplied by the company's statutory tax rate (regardless of the current intrinsic value of the stock), and it reduces the company's reported tax expense. Upon recognition of a tax deduction (at either vest or release of the shares), the actual tax savings resulting from the deduction is compared to the estimated benefit recorded earlier. Any difference in the two amounts is recorded to tax expense.

Recognition of Compensation Cost - Implicit Service Period

The explicit service period is stated in the terms of the award. The implicit service period is inferred from the terms of a performance award and can generally be seen in performance awards with performance conditions that affect the timing of vesting.

ESPP - Fair Value

The fair value of the option granted under an employee stock purchase plan is comprised of up to three components: • For all purchase plans, the fair value includes the discount provided under the plan, as calculated on the enrollment date. • For purchase plans that include a look-back provision, the fair value also includes 85%of the value (determined using an option pricing model) of a call option granted with a price equal to the market value of the underlying stock on the enrollment date. This component of the fair value represents the additional value employees will realize as a result of the look-back if the stock price increases during the purchase period. (The percentage of the fair value of a call option specified here assumes the plan offers a discount of 15%. If the plan offers a smaller discount, the fair value would include a proportionately larger percentage of the fair value of a call option. For example, if the plan offered a 10% discount, the fair value would include 90% of the fair value of a call option.) • For purchase plans that do not limit the number of shares that employees can purchase if the price declines during the purchase period, the fair value also includes 15% of the fair value (determined using an option-pricing model) of a put option with a price equal to the market value of the underlying stock on the enrollment date. This component represents the value of the additional shares employees will be able to purchase if the stock price declines during the purchase period. (The percentage of the fair value of a put option specified here assumes the plan offers a discount of 15%. If the plan offers a smaller discount, the fair value would include a proportionately smaller percentage of the fair value of a put option. For example, if the plan offered a 10% discount, the fair value would include 10% of the fair value of a put option.) Where a plan allows for multiple purchases during a single offering, each individual purchase is valued as a separate option. For example, a 24-month offering that provides for four purchases to occur at 6-month intervals throughout the offering is treated as four options (a 6-month option, a 12-month option, an 18-month option, and a 24-month option), with a separate fair value computed for each option.

Market Condition Awards - Expense recognition for changes in quantity

The first category is awards with changes in the quantity of awards that vest. A performance award can be designed so that the number of awards earned ranges from a downside threshold percentage (typically 0%) to some upside outperform percentage (typically 200%) based on the degree of satisfaction of the performance goal. The goal can be based on a performance condition, a market condition or both. See Exhibit 10-2 for an example of an award where the quantity of award changes.

ESPP - Grant Date

The general definition of the grant date in ASC 718 requires a mutual understanding of the terms and conditions of a share-based payment arrangement. Generally, the date when an ESPP offering begins is the grant date. Treasury regulations connected with IRC §423 specify that the maximum number of shares that an employee can purchase during an offering must be established at the offering date in order to establish a grant date for tax purposes. This is not required to establish a grant date for financial reporting purposes. The requisite service period is the period over which the employee participates in the plan and pays for the shares. The period from the offering date through the purchase date is generally the requisite service period.

Grants - Measurement Date - Communication of grant

The grant date occurs when four conditions have been met: The company and the award recipient have a mutual understanding of the key terms and conditions of the award. • The company is contingently obligated to issue equity instruments or transfer assets when the requisite services are rendered. • The required approvals for the grant have been obtained. • The award recipient begins to benefit from, or be adversely affected by, subsequent changes in the price of the company's equity shares. ASC 718-10-25, issued in September 2005, clarifies that a mutual understanding is presumed to exist on the date the board of directors (or other entity with the appropriate authority) approves the grant, provided the following two conditions are met: The grant is unilateral, and the award recipient does not have the ability to negotiate the terms and conditions of the arrangement. • The grant is expected to be communicated to the award recipient in a "relatively short time period," defined as the period in which a company could reasonably be expected to communicate the awards under its customary practices. This period may vary depending on the number of grants involved, the location of the grant recipients (domestic-only or outside the U.S.), and the method used to communicate the grants (paper, electronic, via managers, etc.). Except in rare circumstances where individuals might be expected to reject the grant (e.g., employees outside the U.S. that are subject to tax at grant), the recipient's acceptance of the grant is not required to establish a grant date; mere communication of the key terms and conditions is sufficient.

Modifications - Repricing - Treatment of cancelled option

The original option may be cancelled and a new option may be granted with an exercise price equal to the now lower FMV. This is sometimes referred to as an "option exchange." Type I (Probable-to-Probable): In this type of modification, the grant is likely to vest both before and after the modification. It can include repricing, acceleration of vesting that is not in connection with a termination of employment, and extension of the post-termination exercise period for stock options. In a probable-to-probable modification, the cancellation of the original grant is not treated as a forfeiture, and thus none of the expense previously recorded for the cancelled grant is reversed. Moreover, if the cancelled grant is not yet fully vested, the company continues to record the remaining unamortized expense along with any additional expense for the replacement award, provided that the original vesting conditions are met. There may also be incremental expense for the replacement grant, equal to the grant's current fair value less the fair value of the cancelled grant at the time of the cancellation.

Recognition of Compensation Cost - Derived Service Period

The requisite service period is the period during which an employee is required to provide service in exchange for stock-based compensation. It defines the period of time that the expense of an award will be amortized. Generally, it should consider explicit, implicit, and derived service periods, depending on all of the terms of an award. Further, the requisite service period will define the period of time that compensation expense can be reversed, in the event of employee termination. g. The derived service period is calculated from the same valuation techniques used to determine fair value, as discussed in paragraph 10.10.2 and can generally be seen in performance awards with market conditions that affect the timing of vesting. From the valuation model, the derived service period represents the duration of the median of the distribution of share price paths on which the market condition is satisfied.

Valuation Factors - Interest Rate Selection

The risk-free interest rate. Generally, companies use the current Treasury rate applying to bills or bonds with terms equal to the award's expected term because the prescribed zero-coupon rate on U.S. government issues is not as readily accessible. When there is no corresponding Treasury rate for the expected term, for example a six-year expected term, the existing rates are usually averaged or interpolated to derive an interest rate for that term.

ASC 260 - Diluted EPS - RSAs/RSUs

The same earnings per share approach applies to restricted stock and units payable in stock. Although restricted stock is issued at grant, for earnings per share purposes it is not considered issued and outstanding until it is vested; while the award is unvested, it is treated as a stock option with a price of $0. Assume that a 10,000-share restricted stock award is granted on January 1, 20X1, when the market value is $10 per share, and is scheduled to vest in full four years after the date of grant. The company is calculating earnings per share for 20X3 (the company's fiscal year corresponds with the calendar year), when the average market value is $25 per share. Since the stock is issued at no cost, there are no exercise proceeds that can be applied to repurchase stock. The average unamortized expense for the award is still considered a source of repurchase funds. The average unamortized expense for the award in 20X3 (the reporting period) is $37,500 ($50,000 of unamortized expense at the beginning of the year and $25,000 of unamortized expense at the end of the year). This would enable the company to repurchase 1,500 shares at $25 per share (the average market value over the period). The net increase to the diluted earnings-per-share denominator as a result of the award is 8,500 shares (10,000 shares of restricted stock outstanding less 1,500 shares repurchased with the unamortized expense). Where dividends are paid on unvested awards and the dividends are not subject to forfeiture, the company is required to use the two-class method when reporting earnings per share. The two-class method is typically used by companies with multiple classes of common stock or with other securities that participate in dividends paid to common stockholders. The method uses a formula to allocate earnings (the numerator of the EPS equation) to each security. Thus, separate EPS calculations would be required for the company's unvested awards and the rest of its common stock.

Valuation Factors - Volatility

The underlying stock's expected volatility. For public companies, this is a best estimate of the market volatility over the expected term of the option. Public companies often use historic volatility rates to assist in this determination. They may also use implied volatilities or a blend of historic and implied. Private companies that cannot produce a reliable estimate of their stock volatility generally use peer company volatility (often the same peer companies that were used for 409A valuation purposes) or industry indices. Public companies are not allowed to use industry indices as a volatility source.

Modifications - Type of Modifications

Under ASC 718, a modification is any change to the existing terms of an equity grant that affects the (1) fair value, (2) vesting, or (3) classification (liability vs. equity).10 A modification is treated as the exchange of the original grant for a new grant. In some types of modifications, the original expense continues to be recognized. If the replacement grant is worth more than the grant it replaces, incremental expense is calculated and recognized. Examples of modifications include acceleration of vesting upon termination if the original grant doesn't allow for it, a repricing in which an underwater stock option is replaced with a new award, or a change that makes a stock-settled award into a cash-settled award. The examples in ASC 718-2-55-107 through 121 classify modifications to vesting criteria as one of four types of modifications, based on the probability of the grants vesting before and after the modification: • Type I - probable to probable • Type II - probable to improbable • Type III - improbable to probable • Type IV - improbable to improbable For Type I and Type II modifications, the grants are valued immediately before and immediately after the modification. The incremental expense is the additional value added by the modification, so incremental expense is determined by subtracting the fair value calculated immediately before the modification from the fair value after the modification. For Type III and Type IV modifications, any expense for unvested awards is reversed/discontinued. A new fair value for the replacement award is calculated and used instead. If an award is canceled for some reason other than a termination without any replacement award or other compensation, the expense is not reversed since the award was not forfeited.11 Instead, the unamortized expense for the canceled award is accelerated into the current reporting period, since there is no longer any remaining service period associated with the award. A change that is triggered under the existing terms of an award is not a modification. For example, acceleration of vesting when a change in control occurs is not a modification as long as the provision was in the terms of the award before the event that triggered the change. Further, if a company withholds shares for taxes in excess of the statutory maximum, liability accounting is triggered, but this is not strictly considered a modification under ASC 718 since the underlying terms of the award have not been changed.

Modifications - Definition

Under ASC 718, changes to the terms of an award that meet any of the following conditions must be accounted for as modifications:1 • The fair value of the award just after the modification differs from the award's fair value just before the modification. • The vesting conditions of the award are changed. • The accounting treatment of the awards is changed from equity to liability or vice versa. Type I (Probable-to-Probable): In this type of modification, the grant is likely to vest both before and after the modification. It can include repricing, acceleration of vesting that is not in connection with a termination of employment, and extension of the post-termination exercise period for stock options. In a probable-to-probable modification, the cancellation of the original grant is not treated as a forfeiture, and thus none of the expense previously recorded for the cancelled grant is reversed. Moreover, if the cancelled grant is not yet fully vested, the company continues to record the remaining unamortized expense along with any additional expense for the replacement award, provided that the original vesting conditions are met. There may also be incremental expense for the replacement grant, equal to the grant's current fair value less the fair value of the cancelled grant at the time of the cancellation. • Type II (Probable-to-Improbable): In this type of modification, the grant is likely to vest before the modification but is not expected to vest after the modification. It is significantly less common, but one situation in which it can occur is when vesting is extended as part of a repricing program (because options that were expected to vest under the original, shorter vesting conditions may not be expected to vest under the new, extended vesting conditions). This type of modification is accounted for in a manner similar to a Type I (probable-to-probable) modification. Expense is not reversed for the cancelled grant, and any remaining unamortized expense must be recognized, provided that the original vesting conditions are met. In addition, there may be incremental expense for the replacement grant equal to its current fair value less the fair value of the cancelled grant at the time of the cancellation. • Type III (Improbable-to-Probable): In this type of modification, the grant is not expected to vest before the modification but is likely to vest afterwards. It includes acceleration of vesting upon termination. An improbable-to-probable modification is essentially accounted for as if the unvested portion of the original grant is forfeited and a new, unrelated option or award is granted. No further expense is recognized for the cancelled grant, and previously recorded expense relating to the unvested portion of the grant may be reversed (previously recorded expense related to the vested portion of the grant is not reversed). Additional expense is recognized equal to the current fair value of the portion of the grant that is newly expected to vest after the modification. • Type IV (Improbable-to-Improbable): In this type of modification, the grant is not likely to vest either before or after the modification. No expense is recognized for the cancelled grant. The expense for the new grant will be the current fair value of the grant at the time of the modification, but this expense is recognized only if vesting becomes likely and actually occurs at some point.

Measurement of Compensation Cost - Dividends on RSAs/RSUs

Under ASC 718, dividends and dividend equivalents paid on restricted stock and units are charged to retained earnings. This applies regardless of whether the dividends are paid on a current basis (i.e., at the same time the dividend is paid to other shareholders) or on a deferred basis (i.e., not until the underlying award is paid out). It also applies whether the dividends are paid in cash or stock and whether they are paid on restricted stock or restricted stock units. When the award is granted, the fair market value of the underlying stock already includes the value of the future dividend payments (i.e., when investors are buying and selling the stock, the prices they agree on should take into account the future dividend stream the buyer will be entitled to and the seller is giving up). Since the expense the company recognizes is based on this fair market value, when the dividends are actually paid there is no need for the company to recognize any further expense. As mentioned above, for restricted stock arrangements that are not entitled to dividends before vesting but where the company does pay dividends on the underlying stock, the fair value of the award is reduced by the present value of the dividends that will be paid over the vesting period of the award. For example, assume that restricted stock units are granted when the fair market value is $40 per share and that the present value of the dividends the company expects to pay over the vesting period of the award is $2 per share. If the company pays dividend equivalents on the unvested restricted stock units, the fair value of the unit award is $40 per share (the fair market value on the date the award is granted). If the company does not pay dividend equivalents on the unvested units, the fair value of the award is reduced by the present value of the future dividend stream, to $38 per share.

Tax Accounting - Non-Qualified Arrangements

Under ASC Subtopic 718-740, expense for equity compensation awards should be offset (must be reduced) by the anticipated tax benefit that may be realized in the future from those awards. Companies generally receive tax deductions for amounts that employees recognize as ordinary income, usually upon settlement of an award. For equity compensation awards that will result in a tax deduction for the company at settlement (i.e., awards except ISOs and Section 423 ESPPs), the company recognizes the anticipated tax deduction in parallel with the expense recognized for the award. This accounting entry to anticipate a future tax benefit is referred to as a deferred tax asset (DTA) and is simply the recognized expense of the award multiplied by the corporate tax rate of the company. Most companies receive only limited tax deductions for equity outside the U.S., so DTA is often recorded only for grants to U.S. participants. Also note that deferred tax assets are never recorded for ISOs or Section 423 ESPPs since a tax deduction occurs only upon a disqualifying disposition and thus is not guaranteed and therefore cannot be anticipated.

ASC 260 - Basic EPS - Effect of Stock Compensation

Under GAAP, an earnings-per-share (EPS) computation must be presented by publicly held companies. This information is used by investors to assess the profitability and the performance of the company from period to period and to compare the company to other businesses. Simply put, the EPS computation involves spreading the company's earnings for the period being reported over the number of common equity securities outstanding during such period. For purposes of this computation, the company's shares of stock are weighted for the actual time that such shares were outstanding during the period. For example, if a participant exercised 1,000 options halfway through the period, only 500 shares would be included when calculating basic EPS. The current requirements for calculating EPS are set forth in ASC Topic 260. The standard requires the presentation of both "basic" and "diluted" EPS. The basic EPS computation does not take into consideration the effects of dilution. It is calculated by dividing the income available to common shareholders for the reporting period by the weighted average number of shares of common stock actually outstanding during that period, without factoring in any potentially issuable securities that could have a dilutive effect on the company's outstanding shares of stock, such as stock options, unvested restricted stock and other stock awards. Shares of stock issued during the period and shares reacquired during the period are weighted for the portion of the period that they were outstanding. As is the case with other types of stock-based awards, SARs are excluded from basic earnings per share. Where SARs can be settled in cash only, they are excluded from diluted earnings per share as well as basic earnings per share. Where SARs can be settled in cash or stock, the presumption generally is that the SARs will be settled wholly in stock and they are included in diluted earnings per share in the manner described above, provided that their inclusion produces a more dilutive result. However, where settlement in cash or stock is at the company's discretion (rather than the award holder's discretion) and the company can demonstrate through historical experience or stated policy that the SARs will be settled in cash, they can be excluded from diluted earnings per share as well as basic earnings per share. Assume a company has net income of $2.5 million for fiscal 2023. The company has 50,000 shares of preferred stock outstanding that pay an aggregate annual dividend of $250,000, and the weighted average number of common stock outstanding during 2023 equaled 1,000,000. Net Income (2.5) less Dividends (500K) = 2.25 M / 1 M = 2.25 Basic EPS.

International -IFRS 2 - Graded vesting valuation

Under IFRS 2, however, when options are subject to graded vesting, it is necessary to compute a separate fair value for each vesting tranche. Each tranche may have a different expected term, which may also affect the expected volatility, expected dividend yield, and interest rate assumed for the tranche.

SAB 107 - Valuations - Determining Expected Term

Under either model, however, expected exercise behavior can have a significant impact on option values. Options that are outstanding for longer periods or where option holders are expected to realize higher gains at exercise will have higher fair values. In addition, the period the option is expected to be outstanding determines the period over which expected dividend yields, interest rates, and volatility are estimated. Historical data provides a starting point for determining expected exercise behavior, but it is important to consider factors that could cause future behavior to differ from past transactions, including the following: Contractual Requirements and Limitations-Clearly, the expected term should not be longer than the contractual term of the option. Pursuant to SAB No. 107, the expected term also should not be shorter than the option vesting period, Stock Price, Outstanding Options, Employee Terminations, Forfeitures, Participant Demographics, Industry Data: To the extent that it is available, companies may also want to consider industry data on exercise patterns. SAB No. 107 specifically permits the use of peer company data to estimate expected term. While this data is not widely available as of this writing, it is expected to become available over the next few years. For public companies that have insufficient historical data or that feel that historical exercise patterns are not reflective of current grants (for example, where the vesting, expiration, or other terms of new grants differ materially from prior grants), SAB No. 107 permits companies to assume the expected term is the average of the vesting period and the contractual term of the option (referred to as the "simplified method"). For example, if an option is subject to four-year cliff vesting and a contractual term of ten years, the company could assume an expected term of seven years. This formula can only be relied on for "plain vanilla" options, which the bulletin defines as service-based, at-the-money options where, upon termination, unvested shares are forfeited and vested shares are exercisable for a short period. The simplified method is available only to public companies, but ASU 2016-09 amended ASC 718 to include a practical expedient that private companies may rely on to determine expected term in certain circumstances. The practical expedient is discussed in chapter 13 of this book. Companies that grant options to only a small group of consultants or other nonemployees may find that they do not have sufficient historical data to estimate the expected term for the options granted to these individuals. They may also find that the historical exercise and termination behavior of employees is not relevant for purposes of estimating the expected term of options granted to nonemployees. In this case, companies may choose to value options granted to nonemployees using their contractual term. It is not clear that the simplified method may be relied for options granted to nonemployees.

Modifications - Repricing - Incremental Cost

When a company has experienced a decline in its stock price, it may find that a substantial portion of its stock options are underwater— that is, the options have an exercise price that is higher than the current value of the underlying stock. While the options may still have potential future value if their expiration is not imminent, at the current time the options are relatively worthless. Since the options are intended to serve as compensation, this can be problematic for the granting corporation. To address this situation, some companies modify the underwater options to reduce their exercise price. Modifications to reduce option exercise prices can be accomplished using a number of different approaches, including the following: • The grant agreement for the option may simply be amended to reduce the option price with no other modifications to the option. • The original option may be cancelled and a new option may be granted with an exercise price equal to the now lower FMV. This is sometimes referred to as an "option exchange." • The number of shares underlying the option may be reduced along with the exercise price. This is sometimes referred to as a "value-for-value" exchange. The shares are reduced such that the fair value of the option is the same both before and after the modification, which eliminates any incremental expense for the modification. • The optionee may be required to accept additional terms or restrictions, such as extended vesting, in exchange for the reduced exercise price. Some practitioners use the term "repricing" to refer to an exercise price reduction in which the shares underlying the option are not reduced and use the term "value-for-value exchange" to refer to an exercise price reduction in which the shares underlying the option are also reduced to eliminate the incremental expense that would otherwise result from the modification. Regardless of the approach an terminology used, the same accounting principles apply to all option price reductions. Under ASC 718, an option price reduction can include virtually all of the types of modifications discussed in the opening to this chapter, especially if the new grants are subject to additional vesting requirements. In practice, however, most repricings are treated as a Type I (probable-to-probable) modification. The following principles apply: 1. None of the expense for the original options is reversed. 2. If the options are not yet fully vested, the remaining unamortized expense must still be recognized. If additional vesting requirements are imposed on the new grants, this expense can be recognized over either the original vesting period or the new period (but must be recognized if the original vesting conditions are met, even if the new grants are forfeited due to failure to meet the new vesting requirements). 3. Incremental expense is recognized to the extent that the aggregate fair value of the options immediately after the modification exceeds their aggregate fair value immediately beforehand. This expense can be eliminated by reducing the number of shares underlying the options commensurately with the increase in the options' fair values.

Modifications - Award Classification Changes

When an equity award is modified such that it is no longer eligible for equity treatment, the modification is accounted for in the following manner: 1. In the period of the modification, the company recognizes an expense equal to the amount by which the current fair value of the award exceeds the expense already recognized for it (adjusted proportionately for the percentage of the service period that has elapsed). If the current fair value is less than the original grant date fair value, the company will not record any additional expense in this period but also will not reverse any previously recognized expense. 2. In each subsequent fiscal period until the award is settled, the company will record expense based on the then-current estimate of the award's fair value. At no point can the cumulative expense recognized for the award be less than the cumulative expense that would have been recognized based on the original grant date fair value of the award if it had not been modified. 3. In the period the award is settled, the company will record a final expense to true up the prior estimate to the fair value of the award on the settlement date. The aggregate expense cannot be less than the award's aggregate original grant date fair value. When a liability award is modified to be an equity award, the modification is accounted for in the following manner: 1. The company recognizes incremental expense equal to the amount by which the aggregate fair value of the equity award after the modification exceeds its fair value just before the modification. 2. Expense for the liability award is recorded through the modification date, at which point the expense will be fixed at the then-current fair value. Any unamortized expense for the modified award is recorded over the remaining service period.

Grants - Measurement Date - Grants contingent on approval

Where grants are contingent upon additional approval, such as shareholder approval, the grant date does not occur until such approval is obtained and no expense is recognized for the grants before this point. For example, if grants are contingent upon shareholder approval of the plan under which they are issued (or an allocation of additional shares to the plan), the grant date does not occur until the required shareholder approval is obtained. Where the grant itself is not contingent, but will be settled in cash in the absence of additional approval (such as shareholder approval of an allocation of shares to the plan), the grant is subject to liability treatment until such approval is obtained.

Modifications - Award cancelled for no consideration

Where options and awards that, under their terms, were to have been settled in stock are settled or cancelled in any situation other than a forfeiture, there is no reversal of previously recognized expense. Moreover, if the award holder is not receiving a new equity award in exchange for the cancellation or settlement, any remaining unamortized expense is recognized immediately in the period that the settlement or cancellation occurs. If the awards are not fully vested at the time of the settlement or cancellation, the transaction is viewed as effectively vesting the awards in full, triggering recognition of any remaining unamortized expense. If the award holder receives a cash payment in exchange for the cancellation or settlement, the amount of the payment that exceeds the award's current fair value is recorded as additional compensation expense in the period the cancellation/settlement occurs.

ESPP - Period over which expense is accrued

Where the Offering Period and Purchase Period are the same length, the expense is recognized on a straight-line basis over the length of the Offering. Where purchases occur periodically throughout the offering, companies can choose to recognize expense on a straight-line basis over the duration of the offering or can choose to record expense for each purchase period from the start of the offering (sometimes referred to as the "accelerated attribution method". Under the accelerated attribution approach, expense for the first purchase under the offering is recognized over its respective purchase period, expense for the second purchase is recognized over the period from the offering begin date to the second purchase date, expense for the third purchase (if there is one) is recognized from the offering begin date to the third purchase date and so on. This effectively front-loads the expense recognition, since, in all but the last purchase period, the company is recognizing expense for multiple purchase periods at the same time. Upon implementing an ESPP, companies must make a policy decision as to which attribution method they are going to apply. This decision should not be treated lightly; companies wishing to change attribution methods will have to demonstrate that the new method is better suited to the ESPP and may even be required to file a preferability letter from the company's auditors with their financial statements for the period in which the change is made. Generally, it is expected that most companies will use the same attribution method for the ESPP that they use for other service-based awards under their stock compensation programs.

Tax Accounting - Non-Qualified Arrangements - Excess Tax Benefits

Where the actual tax savings exceeds the previously recorded estimate (an "excess tax benefit"), tax expense is reduced. If the actual tax benefit is larger than the DTA recorded, the company records the difference (called a "windfall" or "excess tax benefit") as a decrease to tax expense on the income statement in the period in which it occurs. For disqualifying dispositions of ISOs and Section 423 ESPP shares, the full tax deduction amount is recorded as a tax benefit since no DTA is booked while expense is recognized.

Grants - Measurement Date - Discretion over award payouts

Where vesting is contingent on performance conditions, the grant date cannot occur until the performance conditions have been established. The grantor and grantee cannot have a mutual understanding of the key terms and conditions of the grant until this time. Some arrangements provide the board with discretion over the payout of performance awards. If it is unclear in what situations this discretion would be exercised (even where the board only has discretion to decrease the payout), this could prevent a mutual understanding of the terms of the award from being established, thereby delaying the grant date until the award is paid out.

Recognition of Compensation Cost - Non-Substantive Service Conditions

Where vesting requirements are non-substantive, i.e., where it is assured that the grant will vest, the service period may be deemed to have been completed at grant. For example, where vesting is automatically accelerated upon retirement (or continues after retirement), the vesting requirements for options or awards granted to employees eligible for retirement are considered non-substantive (because the grants will not be forfeited upon termination). Thus, all expense for these grants is recorded immediately in the period they are granted, regardless of their vesting schedule. Where grants subject to such vesting acceleration or continuation provisions are made to employees who will become eligible for retirement before the stated vesting period is complete, expense should be recorded over the shorter period in which the employee becomes eligible for retirement. For example, if a grant with a stated vesting schedule of four years is issued to an employee who will be eligible for retirement in one year, and vesting in the grant is automatically accelerated upon the employee's retirement, expense for the grant is recorded over the one-year period that elapses before the employee becomes eligible for retirement.

Modifications - Measurement date

With a Type I modification, the incremental fair value that results from the modification (the amount by which the fair value of the award immediately after the modification exceeds the fair value of the award immediately before the modification) is added to the grant date fair value of the award when calculating compensation expense. For vested awards, the incremental expense is recognized immediately. For unvested awards, the incremental expense is recognized over the remaining service period. FASB stated that it believed that Type II modifications would be rare. Consequently, the guidance for Type II modifications was included in ASC 718 "for the sake of completeness." With a Type II modification, the original award will continue to be expensed as long as the award would have vested based on its original terms. If conditions change after the modification such that the award vests based on the modified terms, the expense will be based on original grant date fair value, plus any incremental fair value resulting from the modification. This type of modification is uncommon. With a Type III modification, because the award was not expected to vest based on the original terms, the original award is accounted for as if it were cancelled and replaced with a new award. No compensation expense is recognized based on the fair value of the award as of the date of grant. The compensation expense is instead based on the fair value of the modified award. If the modified award is vested (i.e., accelerated vesting was part of the modification) the modification date fair value is immediately recognized as compensation expense. If the modified award is unvested, the modification date fair value is recognized as compensation expense over the remaining vesting period. With a Type IV modification, no compensation expense has been recognized for the original award because vesting was not probable based on its original terms. If conditions change after the modification such that the award vests based on the modified terms, the expense will be based on the modification date fair value. No expense will be recognized based on the original grant date fair value.

Liability Treatment - Cash Settlements

the measurement date for cash-settled awards does not occur until the settlement date, meaning the date of exercise, vesting, or expiration. Because the measurement date fair value is not known until the award is settled, the company must remeasure fair value each reporting period by calculating the current fair value of the grant, i.e., using an option-pricing model to estimate the fair value just as with stock-settled awards (for RSUs, the current market value is used for remeasurement). If the company is publicly traded, the current trading price must be used; if private, the company may choose to use either the current value of the underlying stock or its intrinsic value (i.e., the difference between the exercise price of the option or SAR and the current market value of the underlying stock). Phantom stock awards, also known as cash-settled RSUs, are also subject to liability treatment because they pay out in cash. Thus, the fair value is not finalized until settlement (i.e., the vesting date). The intrinsic value is recalculated each reporting period and the recognition of expense is based upon the latest fair value. The full fair market value of the shares underlying the award must ultimately be treated as an expense unless the award is forfeited