Contents

1. Determining the fair value of equity instruments granted | Croner-i Tax and Accounting
2. Employee Share Options (ESOP’s)
3. A General Overview of Expensing an Option
4. 5.4 Determining the fair value of equity instruments granted

Determining the fair value of equity instruments granted | Croner-i Tax and Accounting

The Financial Accounting Standards Board and the Internal Revenue Service requires public companies to use a fair value method when estimating the value of stock options. Calculating the value of a stock option before it is used to buy or sell stock is difficult because it is impossible to know what the market value of the stock will be when the option is finally exercised.

It's so difficult that Robert C. Merton and Myron S. Scholes actually received the Nobel Prize in Economics for their work in creating a method to calculate the fair value of stock options: the Black-Scholes method. Their research has been used as a basis to pricing several financial instruments and to provide more efficient risk management.

There are several ways of estimating the fair value of stock options. The Financial Accounting Standards Board requires public companies to choose which method they wish to use to calculate the fair value of stock options. However, nonpublic companies can choose the intrinsic method, which simply deducts the price of the stock option for the current market price.

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The Black-Scholes method tackles the uncertainty of pricing stock options by assigning them a constant dividend yield, a risk-free rate and fixed volatility over time. This method was designed for stock options in European markets, where they cannot be exercised -- sold or bought -- until the options expiry date.

However, in the United States, where most stock options are traded, stock options may be exercised at any time. Needless to say, the Black-Scholes method provides only a rough estimate of a stock option's value -- an estimate that can be particularly unreliable in periods of high market volatility. The lattice model for estimating the fair value of stock options creates a number of scenarios in which the options have different prices.

Employee Share Options (ESOP’s)

Each price works as branches on a tree that originate from a common trunk and from which new scenarios can be created. The model then can apply different assumptions, such as the the behavior of employees and stock volatility, to create a potential market value for each potential price.

This model also takes into account the possibility investors may exercise their option before the expiry date, which makes it more relevant for stock options traded in the United States. Those plans include all arrangements by which employees receive shares of stock or other equity instruments of the employer or the employer incurs liabilities to employees in amounts based on the price of the employer's stock. Examples are stock purchase plans, stock options, restricted stock, and stock appreciation rights.

A General Overview of Expensing an Option

This Statement also applies to transactions in which an entity issues its equity instruments to acquire goods or services from nonemployees. Those transactions must be accounted for based on the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable. This Statement defines a fair value based method of accounting for an employee stock option or similar equity instrument and encourages all entities to adopt that method of accounting for all of their employee stock compensation plans.

However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by APB Opinion No. The fair value based method is preferable to the Opinion 25 method for purposes of justifying a change in accounting principle under APB Opinion No. Entities electing to remain with the accounting in Opinion 25 must make pro forma disclosures of net income and, if presented, earnings per share, as if the fair value based method of accounting defined in this Statement had been applied.

Under the fair value based method, compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date or other measurement date over the amount an employee must pay to acquire the stock.

Most fixed stock option plans-the most common type of stock compensation plan-have no intrinsic value at grant date, and under Opinion 25 no compensation cost is recognized for them.

Compensation cost is recognized for other types of stock-based compensation plans under Opinion 25, including plans with variable, usually performance-based, features. For stock options, fair value is determined using an option-pricing model that 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 and the expected dividends on it, and the risk-free interest rate over the expected life ofthe option. Nonpublic entities are permitted to exclude the volatility factor in estimating the value of their stock options, which results in measurement at minimum value.

5.4 Determining the fair value of equity instruments granted

The fair value of an option estimated at the grant date is not subsequently 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 usually referred to as restricted stock awarded to an employee is 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: a the discount is relatively small 5 percent or less satisfies this condition automatically, though in some cases a greater discount also might be justified as noncompensatory , b substantially all full-time employees may participate on an equitable basis, and c the plan incorporates no option features such as 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.

Some stock-based compensation plans require an employer to pay an employee, either on demand or at a specified date, a cash amount determined by the increase in the employer's stock price from a specified level. The entity must measure compensation cost for that award in the amount of the changes in the stock price in the periods in which the changes occur.