Accounting for Equity Compensation

A required text for the Certified Equity Professional program

5th ed. (2008). 294 pp. (8.5" x 11"), softcover. $35 for NCEO members; $50 for nonmembers.

Now more than ever, it is crucial for everyone involved with equity compensation in the U.S. to have a strong foundation in the financial accounting rules that govern equity compensation programs. This book, written by leading experts, provides that foundation. It is updated and expanded for 2008 (including a new chapter 20) and covers the current accounting standard (Statement of Financial Accounting Standards No. 123 (revised 2004) ("SFAS No. 123(R)").

Part 1: Accounting for Equity Compensation Under SFAS No. 123(R)
Chapter 1: Introduction: How Did We Get Here?
Chapter 2: Overview of the Standard
Chapter 3: Measurement Date
Chapter 4: Measurement of Expense
Chapter 5: Expense Attribution
Chapter 6: Accounting for Tax Effects
Chapter 7: Financing Exercise Transactions and Tax Withholding
Chapter 8: Modifications
Chapter 9: Business Combinations
Chapter 10: Earnings per Share
Chapter 11: Employee Stock Purchase Plans
Chapter 12: Stock Appreciation Rights
Chapter 13: Private Companies
Chapter 14: Disclosures
Chapter 15: Effective Date and Transition Methods
Chapter 16: Examples
Part 2: Special Topics
Chapter 17: Valuation Models Chapter 18: Expected Term
Chapter 19: Volatility Estimation
Chapter 20: Expense Recognition for Market and Performance Awards
Glossary
Index

Excerpts

From Chapter 4, "Measurement of Expense"

Although SFAS No. 123(R) precludes including the likelihood of forfeiture as a model input, it does allow the use of models that incorporate a variety of other inputs, such as blackout periods or Rule 10b5-1 trading plans. In some cases, different types of stock options may require one to use a different model. Options in which vesting is contingent on performance goals related to stock price performance should be valued using a model that takes into account the likelihood of the price targets being achieved. Indexed options should be valued using a model that takes into account the possibility of the option price changing over time.

One challenge in applying lattice models to employee stock options is the amount of data required to apply these models. To determine the suboptimal exercise factor, it is necessary to analyze historical exercises based on the market value at the time of exercise, and the historical data must be relevant to the options the company is currently granting. If the options in the historical analysis were granted while the company was private and the company is now publicly held, or if the options were exercised in a different market environment than currently exists, the historical exercise behavior may not be indicative of how employees will exercise the current option grants. It may be necessary to analyze the historical transactions based on population data as of the time the exercises occurred so that trends can be identified by population characteristics, enabling the model to be applied differently to each group of employees. It is also necessary to analyze the probability of employees terminating while holding vested options, which is likely to differ by employee population. These two inputs require a substantial amount of exercise and termination data. In addition to these inputs, it is now necessary to estimate not just a single future volatility but how the stock volatility is expected to change over the contractual term of the option (usually a 10-year period). The same evaluation must be applied to the estimate of expected dividend yield.

From Chapter 17, "Valuation Models"

Consider the core of any option-pricing technique, including that of the BSM formula, as illustrated in figure 17-1, which provides a tree or lattice of stock prices across time. The prices form diagonal patterns across a plane, signifying the simple fact that stock prices can move up and down over time. Notice how some paths are exceptional (frequent upward movements), others are miserable (frequent downward movements), and most reflect lesser extremes.

All option-pricing techniques deploy a map of stock prices—alternative paths the stock price may follow across time—such as that shown in figure 17-1. The fair value of an option (the cost to the company) is equal to the greater of zero or the difference between the stock price at settlement and the strike price. Of particular importance and illustrated in figure 17-1 is the possibility of many different outcomes: the entire point of the valuation task is to model all the different directions or paths the stock price may take and the cost of the option under each possibility. Each path is equally likely. The intuition is that if a more likely price for the future were known in the present day, then the present-day stock price would move in response to that knowledge. As such, it is presumed that current prices reflect all available information and future movements are considered random.

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