A Road Map for Share-Based Compensation: Find the Best Strategy for Rewarding Employees
EXECUTIVE SUMMARY * Since FASB Statement no. 123(R) began requiring companies to recognize an expense equal to the grant-date fair value of options awarded as compensation, there has been a significant change in share-based payments to employees. Companies are taking a fresh look at the alternatives available to compensate employees and minimize the effect on financial statements. * Share-based employee compensation awards are classified as either equity instruments or liability instruments. The measurement date for estimating the fair value of equity instruments is the grant date; the measurement date for liability instruments is the settlement date. Different rules also apply to public vs. private companies depending on the type of award instrument. * Restricted stock and stock units are popular with public companies; stock options continue to be the most popular choice for private companies. * When weighing the pros and cons of various compensation awards, CPAs should help companies consider factors such as the potential dilutive effect on earnings per share, the accounting costs of competing alternatives and the tax implications to both employer and employee. * Since options have long been an attractive tool in recruiting and retaining employees, companies should keep employees' interests in mind as they consider the types of awards they grant as compensation. Companies should also consider vesting criteria, exercise period and overall employee eligibility. ********** Before FASB issued Statement no. 123(R), Share-Based Payment, at-the-money options, with an exercise price equal to the market price on the grant date, were the most popular form of share-based compensation. Companies typically used the alternative intrinsic value method to value those options; with a grant-date intrinsic value of zero, the company recognized no compensation expense. Since the release of Statement no. 123(R), companies have had to recognize an expense equal to the option's grant-date fair value. This article summarizes the valuation requirements of Statement no. 123(R) and provides information CPAs can use to help management choose the best share-based strategy for compensating employees. EQUITY AND LIABILITY AWARD INSTRUMENTS Share-based compensation awards are classified as either equity instruments or liability instruments. Statement no. 123(R) provides criteria for the classification and guidance on applying FASB Statement no. 150, Accounting for Certain Instruments With Characteristics of Both Liabilities and Equity, to this issue. Equity instruments require a company to issue equity shares to employees in a share-based payment arrangement. Common types of equity instruments include equity shares, share-settled stock units (also known as phantom stock), stock options and similar share-settled stock appreciation rights (share-settled SARs). Liability instruments generally require the entity to use cash or noncash assets to settle a share-based payment arrangement. The common liability instruments are cash-settled stock units and cash-settled SARs. Although the best estimate of fair value for both types of awards is the observable price of identical or similar instruments in an active market, such information is generally not available. Consequently, companies need to estimate fair value. Statement no. 123(R) says the measurement date for equity instruments awarded to employees is the grant date; the measurement date for liability instruments is the settlement date. Because settlement occurs after the employee has rendered the services, companies must remeasure a liability instrument's grant-date fair value at each reporting date until all award units are settled--either by forfeiture, exercise or expiration. VALUATION MEASUREMENT GUIDELINES Whether a company is public or private will determine how it measures the value of share-based employee compensation awards. …