The Financial Accounting Standards Board (FASB) establishes financial accounting and reporting standards for stock-based employee compensation plans. Generally these plans occur when employees receive shares of stock or other equity instruments of the employer in amounts based on the price of the employer’s stock. Common examples are employee stock purchase plans (ESPP), stock options and restricted stock.
Measuring the fair market value of these plans is often the the most difficult aspect of compensation for employer and employees to understand. For emerging companies relying heavily on stock and stock options to lure employees knowing the compensatory status of these plans can seriously affect a company’s bottom line.
The FASB determines a fair value for stock options by using an option-pricing model. This model takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, the expected dividends on it, and the risk-free interest rate over the expected life of the option. An option’s fair value that is estimated at the grant date is not later adjusted for changes in the price of the underlying stock or its volatility, the life of the option, dividends on the stock, or the risk-free interest rate.
The fair value of a share of nonvested stock or “restricted stock” awarded to an employee is usually measured at the market price of a share of a nonrestricted stock on the grant date unless a restriction will be imposed after the employee has a vested right to it, in which case fair value is estimated taking that restriction into account.
An employee stock purchase plan that allows employees to purchase stock at a discount from market price is not compensatory if it satisfies three conditions:
- The discount is relatively small (This element is automatically satisfied if the discount at issue is 5 percent or less. However, in some cases a greater discount also might be justified as noncompensatory),
- all full-time employees may participate on an equitable basis, and
- the plan incorporates no option features (i.e. allowing the employee to purchase the stock at a fixed discount from the lesser of the market price at grant date or date of purchase).
In deciding this process, the FASB Board noted that a look-back option can have substantial value because it enables the employee to purchase the stock for an amount that could be significantly less than the market price at date of purchase. A look-back option is not an essential element of a broad-based plan aimed at promoting employee stock ownership. Therefore, broad-based plans that contain look-back options cannot be treated as noncompensatory
Once an option is repriced, it must be accounted for as a variable option, giving rise to compensation expense for subsequent appreciation in the stock price from the time the option is repriced to the time it is exercised. For this purpose, a repricing is defined broadly to include the grant of new options in connection with the cancellation of old, higher-priced options (i.e., an option exchange).
When an option is repriced the fixed nature of the stock option no longer exists. In the course of the option’s life the exercise price has been changed, which results in the option to be treated under “variable” accounting rules. This rule requires constant remeasurement of the difference between the exercise price of the stock option and the fair market value of the underlying stock during the life of the option. This process can result in constant uncertain impacts on a company’s income statement. For this reason, most companies no longer undertake a traditional “repricing” of stock options.