Employee Stock Options: Intrinsic vs. Fair Value

From a Generally Accepted Accounting Principles (GAAP) perspective, the days of issuing employee stock options without much of an afterthought are long gone for public companies—and soon gone for nonpublic companies. In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (Statement) No. 123(R), Share-Based Payment. Statement 123(R) replaces Statement 123, Accounting for Stock-Based Compensation, and was generally effective for public companies as of July 1, 2005. It will be effective for nonpublic companies as of January 1, 2006.

The primary difference between Statement 123(R) and Statement 123 is that all companies are required to record an expense for the fair value of stock options granted under Statement 123(R) in their financial statements. Previously, under Statement 123, companies were allowed only to disclose the pro forma effect of expensing stock options in their financial statement footnotes, without having to record the expense in their financial statements.

Statement 123(R) will have a tremendous impact on companies, especially those in the technology industry. Tech companies historically have relied heavily on stock options to award and retain key employees, instead of using cash incentives.

Under Statement 123, companies were allowed to only disclose the effects of expensing the fair value of stock options granted. However, they were still required to record any intrinsic value of the stock options granted as an expense. Accounting Principles Board Opinion (Opinion) No. 25, Accounting for Stock Issued to Employees, addressed the intrinsic value of stock options and their impact on the financial statements. Similar to Statement 123, Opinion 25 is also replaced by Statement 123(R).

The intrinsic value of a stock option is best explained in the following example:

The company grants a key employee 10,000 stock options to purchase shares of the company’s common stock. On the date of grant, the market price of the common stock is $50 per share. The stock option’s exercise price (or strike price) is $30 per share. The intrinsic value of each stock option is $20 ($50 common stock market price, minus $30 exercise price, equals $20 intrinsic value). Assuming there is no vesting required on the employee’s part, the company would be required to record $200,000 in compensation expense in the year the stock options were granted (10,000 stock options granted at an intrinsic value of $20). Ordinarily, a service or vesting period is required before an employee has the right to exercise stock options. If we were to assume a vesting period of three years for this example, the company would record $66,667 in compensation expense per year ($200,000/ divided by 3 years, equals $66,667).

What would the effect on the company’s financial statements be if the market price of the common stock was $30? The answer is zero ($30 market price, minus $30 exercise price). Under Opinion 25, there would have been no impact on the financial statements. Under the guidance of Statement 123, the company would have had to compute the fair value of the stock options using an option-pricing model, and then disclose the computed expense in its financial statement footnotes. Under Statement 123(R), the company will have to compute the stock options’ fair value and record the computed expense in their financial statements.

There are a number of different ways to compute the fair value of stock options. One of the most popular is the Black-Scholes option-pricing model, which was developed in 1973 to compute the value of publicly traded European stock options. More sophisticated models, such as binomial option pricing, are becoming a more common means of computing the fair value of stock options, because they handle more option plan provisions than the Black-Scholes model does. However, a binomial model requires an expertise often not found within companies. Statement 123(R) does consider the Black-Scholes model to be an acceptable means of computation.

Again, considering the example above, where the market price of the common stock equals the exercise price, the Black-Scholes model may compute the stock option to have a fair value—say $5 per option, depending on certain assumptions such as the volatility of the company’s common stock price and the life of the option (typically 10 years).

Under Statement 123(R), assuming there is no vesting requirement, the company would record a compensation expense of $50,000 in the year the options were granted ($5 stock option fair value multiplied by 10,000 stock options). Under Opinion 25, no such expense would have been recorded and, under Statement 123, the $50,000 pro forma effect on the company’s net gain or loss would have been disclosed only in the company’s financial statement footnotes.

The following table summarizes how stock option expense is generally treated by a company under each of the three GAAP pronouncements:

In regards to a company transitioning to the new guidance, Statement 123(R) allows for three methods:

1. Modified prospective method: Companies follow Statement 123 up to the effective date of Statement 123(R), and then expense all stock options granted and vested after the effective date. Stock options granted but not yet vested prior to Statement 123(R) are included in the expense to be recognized. This method is required for public companies.
2. Modified retrospective method: Similar to the modified prospective method except companies may elect to restate their previously reported years’ financial statements to account for the new provisions of Statement 123(R).
3. Prospective method: Certain nonpublic companies are allowed to follow Statement 123 for stock options granted prior to Statement 123(R)’s effective date, and follow Statement 123(R) for all stock options issued or modified after the effective date. Stock options granted but not yet vested prior to Statement 123(R) are not included in the expense to be recognized. Such options may continue to be accounted for under the provisions of Statement 123 or Opinion 25.

Obviously, Statement 123(R) has and will continue to have a significant effect on companies that issue large numbers of stock options to several employees. This summary presents only a brief overview of the concepts of Statement 123(R). The original pronouncements and associated guidance and interpretations should be used for specific issues you might encounter regarding share-based compensation.

William J. Vogelsang is a director with RSM McGladrey. Mr. Vogelsang serves a variety of industries, including technology, specifically software developers. He can be contacted at 847.940.1300 or via email at [email protected].