SFAS 123
SFAS 123: Expensing of Employee Stock Options
In 2003, the Federal Accounting Standards Board (FASB) declared that all companies must expense the value of their employees' stock options in accordance with SFAS 123, and in the first fiscal year subsequent to June 15, 2005, SFAS 123 commenced. New amendments have been added to the existing SFAS 123 in which the value of the stock option award is determined at the date of the grant.
Under SFAS 123(R), companies are now required to recognize compensation cost from most share-based payment arrangements with employees. They can no longer simply recognize the pro forma cost previously calculated and acceptable under the original SFAS 123. Certain assumptions for computing that cost have been modified under SFAS 123(R). For example, expected volatility will be used as opposed to historical volatility (the original SFAS 123 theoretically used expected volatility but computations were primarily based on historical volatility). Also, companies are required to estimate the number of instruments for which the mandatory service is expected to be rendered when calculating total compensation costs. Under the original SFAS 123, forfeitures were accounted for as they occurred.
The revised standards of SFAS 123 is causing companies to re-evaluate appropriate instruments. Appraisal Economics applies the most up-to-date valuation techniques in compliance with SFAS 123(R) in order to value complex derivative instruments with a detailed narrative report. Whether a comprehensive stock valuation is in order, or ongoing valuation of simple stock options with minimal reporting, Appraisal Economics can provide fully supported, high quality work in a timely manner.
Generally, SFAS 123 allows for the determination of fair market value through the analytical assessment of the Black-Scholes model, a lattice model, or any other model that meets three certain criteria. The model must:
- Be applied in a manner consistent with the fair value measurement objective and other requirements of SFAS 123
- Be based on established principles of financial economic theory as generally applied in that field
- Be reflective of all substantive characteristics of the grant instrument
The Black-Scholes model (BSM) is a formula that determines how much a stock option is worth at any given time and estimates the price someone would pay for that option in the market today. The Black-Scholes model is a remarkably accurate option pricing model that is based on certain terms and assumptions:
- No dividends are paid - the majority of companies pay dividends to their shareholders, which seems like a substantial limitation. However, SFAS 123 still allows the Black-Scholes model by adjusting for this situation. This is done by simply subtracting the discounted value of a future dividend from the stock price.
- Trading in the stock remains continuous - this means the market is efficient and people cannot routinely predict the direction of the market or an individual stock.
- Securities are perfectly divisible - stocks are usually sold in sets of 100. This would mean it is possible to buy 1/100 of a share.
- No transaction costs or taxes - usually market participants have to pay a commission to buy or sell stock options. No commissions can be charged for the SFAS 123 approved Black-Scholes model to be effective.
- Risk-free interest rate is constant and known - typically, the discount rate on U.S. Government Treasury Bills is used to represent the risk-free rate in the model.
The Black-Scholes model uses estimated future volatility of stock price. Future volatility is the estimated predicted variance based on historical stock price data as well as expectations of future stock price movement. Because future volatility is an estimation and cannot be known, SFAS 123 advises using historic volatility as a substitute in certain situations. The Black-Scholes model is an option-pricing technique that is in accordance with SFAS 123 standards and remains pervasive in financial markets.
Lattice-based models also satisfy SFAS 123 criterion. These models use the same basic categories of inputs as the Black-Scholes model, but can reflect adjustments designed to incorporate particular characteristics of employee stock options and other similar instruments. Lattice-based models also accommodate changes in dividends and volatility over the option's contractual terms, estimations of expected option-exercise patterns, and periods when options cannot be exercised (black-out periods). Lattice-based models do not use a straightforward mathematical equation like the Black-Scholes model. They instead use an iterative tactic which involves generating numerous possible outcomes and assigning a probability to each one. Although SFAS 123 does not establish a preference for either a lattice-based model or the Black-Scholes model, companies may find it necessary to employ a lattice-based model when an estimated fair value of more complex share-based awards is needed.
Certain types of performance conditions attached to equity-based instruments will trigger different types of accounting treatment. Here is an example:
- In some instances, target stock prices lead to fixed accounting treatment in which the estimated fair value is determined only as of the grant date, and its cost is amortized over the service period whether or not subsequent conditions are met. In other instances, performance conditions may lead to variable accounting treatment. The estimated fair value remains to be determined as of the grant date, but its cost is periodically adjusted to reflect subsequent performance.
Appraisal Economics will determine the appropriate inputs into the valuation process taking certain factors into consideration such as expected volatility, historical stock option exercise behavior, expected forfeitures, and the estimated life of the option. This information is in compliance with revisions to SFAS 123 and is fully supported by a narrative report suitable for review by independent auditors, the Securities Exchange Commission, and the Internal Revenue Service.
The Right Valuation Services For You
Appraisal Economics has an experienced staff of engineers, CPAs, CFAs, MAIs, ASAs, and Ph.D.s dedicated to providing you with the accurate information you expect and the personal attention you deserve. We assign a senior manager to supervise every project to ensure our valuation techniques are meeting SFAS 123 standards. All of our reports and opinions meet or exceed all relevant professional standards and are subject to rigorous internal review. When you choose Appraisal Economics, you will receive accurate, fully supported information on a timely basis.
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