Objectives
In March 2003, the Financial Accounting Standards Board (FASB)
added a project to address issues related to equity-based
compensation (EBC). The objective of this project is to cooperate
with the International Accounting Standards Board (IASB) in order to
achieve convergence to a single, high-quality global accounting
standard on EBC. The Board added this project to its agenda because
of user concerns, concerns about comparability, and the Board’s goal
of convergence.
This project will address that lack of comparability by resolving
the following main issues: (a) whether compensation paid in the form
of equity instruments (and other EBC arrangements) should be
recognized in the financial statements and (b) how should
compensation in the form of equity instruments (and other EBC
arrangements) be measured in the financial statements. The ultimate
goal is the establishment of one method for the recognition and
measurement of EBC transactions that would be followed by all
companies applying U.S. GAAP and international accounting
standards.
FASB Exposure Draft, Share-Based Payment—an amendment of
Statements No. 123 and 95 (Proposed Statement of Financial
Accounting Standards)
[Download
Exposure Draft]
On March 31, 2004, the FASB issued an Exposure Draft,
Share-Based Payment, that addresses the accounting for
share-based payment transactions in which an enterprise receives
employee services in exchange for (a) equity instruments of the
enterprise or (b) liabilities that are based on the fair value of
the enterprise’s equity instruments or that may be settled by the
issuance of such equity instruments. The proposed Statement would
eliminate the ability to account for share-based compensation
transactions using APB Opinion No. 25, Accounting for Stock
Issued to Employees, and generally would require instead that
such transactions be accounted for using a fair-value-based
method.
Summary of the Exposure Draft
The proposed Statement addresses the accounting for transactions
in which an enterprise exchanges its valuable equity instruments for
employee services. It also addresses transactions in which an
enterprise incurs liabilities that are based on the fair value of
the enterprise’s equity instruments or that may be settled by the
issuance of those equity instruments in exchange for employee
services. The proposed Statement does not change the accounting for
similar transactions involving parties other than employees or the
accounting for employee stock ownership plans, which are subject to
AICPA Statement of Position 93-6, Employers’ Accounting for
Employee Stock Ownership Plans; the Board intends to reconsider
the accounting for those transactions and plans in a later phase of
its project on EBC.
The objective of the accounting required by FASB Statement No.
123, Accounting for Stock-Based Compensation, as it would be
amended by the proposed Statement, is to recognize in an entity’s
financial statements the cost of employee services received in
exchange for valuable equity instruments issued, and liabilities
incurred, to employees in share-based payment transactions. Key
provisions of the proposed Statement are as follows:
- For public entities, the cost of employee services received in
exchange for equity instruments would be measured based on the
grant-date fair value of those instruments (with limited
exceptions). That cost would be recognized over the requisite
service period (often the vesting period). Generally, no
compensation cost would be recognized for equity instruments that
do not vest.
- For public entities, the cost of employee services received in
exchange for liabilities would be measured initially at the fair
value of liabilities and would be remeasured subsequently at each
reporting date through settlement date. The pro rata change in
fair value during the requisite service period would be recognized
over that period, and the change in fair value after the requisite
service period is complete would be recognized in the financial
statements in the period of change.
- The grant-date fair value of employee share options and
similar instruments would be estimated using option-pricing models
adjusted for the unique characteristics of those options and
instruments (unless observable market prices for the same or
similar options are available).
- If an equity award is modified subsequent to the grant date,
incremental compensation cost would be recognized in an amount
equal to the excess of the fair value of the modified award over
the fair value of the original award immediately prior to the
modification.
- Employee share purchase plans would not be considered
compensatory if the terms of those plans were no more favorable
than those available to all holders of the same class of shares
and substantially all eligible employees could participate on an
equitable basis.
- Excess tax benefits, as defined by the proposed Statement,
would be recognized as an addition to paid-in capital. Cash
retained as a result of those excess tax benefits would be
presented in the statement of cash flows as financing cash
inflows. The write-off of deferred tax assets relating to
unrealized tax benefits associated with recognized compensation
cost would be reported as income tax expense.
- The proposed Statement allows nonpublic entities to elect to
measure compensation cost of awards of equity share options and
similar instruments at intrinsic value through the date of
settlement. That election also would apply to awards of liability
instruments. The proposed Statement also requires that public
entities measure compensation cost of awards of equity share
options and similar instruments at intrinsic value through the
date of settlement if it is not reasonably possible to estimate
their grant-date fair value.
- The notes to financial statements of both public and nonpublic
entities would disclose the information that users of financial
information need to understand the nature of share-based payment
transactions and the effects of those transactions on the
financial statements.
History and Background
Opinion 25, issued in 1972, required that compensation cost for
awards of share options be measured at their intrinsic value, which
is the amount by which the fair value of an equity share exceeds the
exercise price. Opinion 25 also established criteria for determining
the date at which an award’s intrinsic value should be measured;
that criteria distinguished between awards whose terms are known (or
fixed) at the date of grant and awards whose terms are not known (or
variable) at the date of grant. Measuring fixed awards’ intrinsic
values at the date of grant generally resulted in little or no
compensation cost being recognized for valuable equity instruments
given to employees in exchange for their services. Additionally,
distinguishing between fixed and variable awards was difficult in
practice, and resulted in a large amount of specialized and complex
accounting guidance.
Statement 123, issued in 1995, was effective for share-based
compensation transactions occurring in fiscal periods beginning
after December 15, 1995. As originally issued, Statement 123
established a fair-value-based method of accounting for share-based
compensation awarded to employees. The fair-value-based method of
accounting requires that compensation cost for awards of share
options be measured at their fair value on the date of grant. As
opposed to the accounting under Opinion 25, the application of the
fair-value-based method to fixed awards results in compensation cost
being recognized when services are received in exchange for valuable
equity instruments of the employer. Statement 123 established as
preferable the fair-value-based method and encouraged, but did not
require, entities to adopt it. The Board’s decision at that time to
permit entities to continue accounting for share-based compensation
transactions using Opinion 25 was based on practical rather than
conceptual considerations.
In November 2002, the FASB issued an Invitation
to Comment, Accounting for Stock-Based Compensation: A
Comparison of FASB Statement No. 123, Accounting for Stock-Based
Compensation, and Its Related Interpretations, and IASB Proposed
IFRS, Share-based Payment, that compares the fair-value-based
method of accounting for EBC in Statement 123 with the fair–value-
based method of accounting for EBC in the proposed IFRS. (Note: The
IASB issued IFRS 2, Share-based Payment, in February 2004.
IFRS 2 is available from the IASB at www.iasb.org.) The Board issued the
Invitation to Comment to achieve two objectives: (a) to provide
information that would be useful to constituents that wished to
comment on the IASB’s IFRS 2 (the comment letter deadline for the
proposed IFRS was March 7, 2003), and (b) to solicit views from
constituents on the key differences between IFRS 2 and Statement 123
and on certain other issues associated with accounting for EBC at
fair value. The comment letter deadline for the Invitation to
Comment was February 1, 2003. The FASB received 302 comment letters
responding to the Invitation to Comment, which were reviewed and
discussed at various Board meetings.
At the March 12, 2003 Board meeting the Board reviewed and
discussed the comment letters received in response to the Invitation
to Comment (See below). The Board also discussed issues relating to
whether a project on EBC should be added to its agenda. At that
meeting, the Board decided to add an EBC project to the agenda. The
Board also decided that the project should be undertaken in
cooperation with the IASB in order to achieve a single, high-quality
accounting standard on EBC.
Reasons for Issuing the Proposed Statement
There are four principal reasons for issuing the proposed
Statement:
- Addressing concerns of users and others. Users of
financial statements, including institutional and individual
investors, as well as many other parties expressed to the FASB
their concerns that using Opinion 25’s intrinsic value method
results in financial statements that do not faithfully represent
the economic transactions affecting the issuer, namely, the
receipt and consumption of employee services in exchange for
valuable equity instruments. Financial statements that do not
faithfully represent the economic transactions affecting an issuer
can distort the reported financial condition and operations of
that issuer and can lead to the inappropriate allocation of
resources. Part of the FASB’s mission is to improve standards of
financial accounting for the benefit of users of financial
information.
- Improving the comparability of reported financial
information through the elimination of alternative accounting
methods. During the summer of 2002, a number of public
companies announced their intention of voluntarily adopting
Statement 123’s fair-value-based method of accounting for
share-based compensation transactions with employees. Since then,
approximately 500 public companies have voluntarily adopted or
announced their intention to adopt the fair-value-based method.
Despite the many public companies that have voluntarily adopted
the fair-value-based method of accounting, there remains a large
number of companies that continue to use Opinion 25’s intrinsic
value method. The Board believes that similar economic
transactions should be accounted for similarly (that is,
share-based compensation transactions with employees should be
accounted for using one method). Consistent with the conclusion in
Statement 123, the Board believes such transactions should be
accounted for using the fair-value-based method.
- Simplifying U.S. GAAP. The proposed Statement would
simplify the accounting for share-based payments. The Board
believes that U.S. GAAP should be simplified whenever possible.
Requiring the use of a single method of accounting for share-based
payment would result in the elimination of Opinion 25’s intrinsic
value method and the many related detailed and form-driven rules.
- International convergence. The proposed Statement would
result in greater international comparability in the accounting
for share-based payment. In February 2004, the IASB, whose
standards are followed by enterprises in many countries throughout
the world, issued IFRS 2. IFRS 2 requires that all enterprises
recognize an expense for all employee services received (and
consumed) in exchange for the enterprise’s equity instruments. The
IASB concluded that share-based compensation transactions should
be accounted for using a fair-value-based method that is similar
in most respects to the fair-value-based method established in the
proposed Statement. Converging to a common set of high-quality
financial accounting standards on an international basis for
share-based payment transactions with employees improves the
comparability of financial information around the world and
simplifies the accounting for enterprises that report financial
statements under both U.S. GAAP and international accounting
standards.
The Board believes that the proposed Statement addresses users’
and other parties’ concerns by requiring enterprises to recognize an
expense in the income statement for employee services received (and
consumed) in exchange for the enterprises’ equity instruments,
thereby reflecting the consequences of the economic transaction in
the financial statements. By requiring the fair-value-based method
for all public companies, the proposed Statement would eliminate an
alternative accounting method and the accounting guidance associated
with that method; consequently, similar economic transactions would
be accounted for similarly. Finally, requiring the use of Statement
123’s fair-value-based method is convergent with IFRS 2.
Differences between the Proposed Statement and Current
Practice
The proposed Statement would affect current practice in a number
of ways, but chief among them is that it would eliminate the
alternative to use Opinion 25’s intrinsic value method of accounting
that was provided in Statement 123 as originally issued. Under
Opinion 25, issuing stock options to employees generally resulted in
recognition of no compensation cost. The proposed Statement would
require public companies to recognize the cost of employee services
received in exchange for equity instruments, based on the grant-date
fair value of those instruments (with limited exceptions).
The proposed Statement would affect current practice in other
ways, including the measurement attribute for nonpublic entities,
the pattern in which compensation cost would be recognized, the
accounting for employee share purchase plans, and the accounting for
income tax effects of share-based payment transactions. Paragraphs
6–15 of the proposed Statement summarize those as well as other
differences.
How the Conclusions in the Proposed Statement Relate to the
FASB’s Conceptual Framework
FASB Concepts Statement No. 1, Objectives of Financial
Reporting by Business Enterprises, states that financial
reporting should provide information that is useful in making
business and economic decisions. Recognizing compensation cost
incurred as a result of receiving employee services in exchange for
valuable equity instruments issued by the employer will help achieve
that objective by providing information about the costs incurred by
the employer to obtain employee services in the marketplace.
With respect to the notion of comparability, FASB Concepts
Statement No. 2, Qualitative Characteristics of Accounting
Information, states that information about an enterprise gains
greatly in usefulness if it can be compared with similar information
about other enterprises. Establishing the fair-value-based method of
accounting as the required method will increase comparability
because similar economic transactions will be accounted for
similarly. That will improve the usefulness of financial
information. Neutrality is another important characteristic of
accounting information. Establishing that method also eliminates the
accounting bias toward using employee share options for
compensation, which results in accounting that is neutral for
different forms of compensation.
Completeness is identified in Concepts Statement 2 as an
essential element of representational faithfulness and relevance.
Thus, to faithfully represent the total cost of employee services to
the enterprise, compensation cost relating to valuable equity
instruments issued by the employer to its employees in exchange for
their services should be recognized in the employer’s financial
statements.
FASB Concepts Statement No. 6, Elements of Financial
Statements, defines assets as probable future economic benefits
obtained or controlled by a particular entity as a result of past
transactions or events. Employee services cannot be stored and are
received and used simultaneously. Those employee services are assets
of an enterprise only momentarily—as the entity receives and uses
them—although their use may create or add value to other assets of
the enterprise. When an employer exchanges its valuable equity
instruments for employee services, the receipt of those employee
services creates an asset that should be either capitalized as part
of another asset of the enterprise (as permitted by U.S. GAAP) or
expensed when consumed.
Costs and Benefits
The mission of the FASB is to establish and improve standards of
financial accounting and reporting for the guidance and education of
the public, including preparers, auditors, and users of financial
information. In fulfilling that mission, the Board endeavors to
determine that a proposed standard will fill a significant need and
that the costs imposed to meet that standard, as compared with other
alternatives, are justified in relation to the overall benefits of
the resulting information. The Board’s consideration of each issue
in a project includes the subjective weighing of the incremental
improvement in financial reporting against the incremental cost of
implementing the identified alternatives. At the end of that
process, the Board considers the accounting provisions in the
aggregate and assesses the related perceived costs on a qualitative
basis.
Several procedures were conducted before the issuance of the
proposed Statement to aid the Board in its assessment of the
expected costs associated with implementing the required use of the
fair-value-based accounting method. Those procedures included a
field visit program, a survey of commercial software providers, and
discussions with Option Valuation Group members, valuation experts,
compensation consultants, and numerous other constituents. Based on
the findings of those cost-benefit procedures, the Board concluded
that the proposed Statement will sufficiently improve financial
reporting to justify the costs it will impose. Paragraphs C40–C47 of
the proposed Statement provide a discussion of the Board’s
cost-benefit assessment with respect to the proposed Statement.
[Download
Cost-Benefit Survey]
The Effective Dates of the Proposed Statement
The proposed Statement would be applied to public entities
prospectively for fiscal years beginning after December 15, 2004, as
if all share-based compensation awards granted, modified, or settled
after December 15, 1994, had been accounted for using the
fair-value-based method of accounting. Nonpublic entities that had
adopted the fair-value-based method of accounting for recognition or
pro forma disclosures would use the same transition and effective
date as public entities. All other nonpublic entities would apply
the proposed Statement prospectively for fiscal years beginning
after December 15, 2005.
