FAS 123R – Part 2: Expensing Stock Options … Demystified

As noted in my recent blog post FAS 123R: You Have to Crawl Before You Can Walk – Part 1, helping busy CFO’s generate the disclosure requirements of FAS 123R (now ASC Topic 718) reminded me a little of watching my one year old learn to walk and the three step process described below. With the goal of creating the requisite financial statement disclosures, I’ll now continue with Part 2 of the three steps a typical privately held, venture-backed company needs to understand for equity compensation reporting of plain vanilla option grants. In case you are more advanced, please note that this article addresses the basics of FAS 123R.

  1. Part 1: Learn to Roll Over – Value the option grants
  2. Part 2: Learn to Crawl – Expense the option grants
  3. Part 3: Learn to Walk – Report the expense and related disclosures

Basic steps to FAS 123RLearn to Crawl – Expensing the Option Grant

In part 1 of this blog series, we reviewed how to generate the fair value of an option grant using the Black-Scholes calculation. That was the easy part. Now, we will use the fair value per share and amortize it over the requisite service period.

In order to understand how to amortize the fair value, you first need to understand the eight items listed below. Using them, you will choose an expensing method and amortize the fair value of the requisite service period. You will then use this amortization schedule to generate the expense for each reporting period. For each reporting period, you may also need to “true-up” the expense being reported, as described below. When expensing your options, keep in mind one of FASB’s guiding principles: At any point in time, you must have expensed the pro rata portion of the fair value based on the portion of the option that has vested.

  1. Fair Value Per Share: This is the value of the option calculated based on the Black-Scholes formula.
  2. Actual Fair Value: Fair Value Per Share x Number Granted = Actual Fair Value. This value is the total amount we will expense for this option over its service period if the employee does not terminate before the option is fully vested.
  3. Requisite Service Period: This is the time period over which you will expense the option grant. When dealing with plain vanilla option grants, this is based on the period the option vests. For example, if the option’s vesting schedule is 25% per year for 4 years, the requisite service period for this option is 4 years.
  4. Forfeiture Rate: This is a projected annual rate that you expect options to be forfeited in the future. Forfeited means options which are cancelled before they vest. It does not include options that expire, meaning options that are cancelled after they vest. This rate is used to discount the amount of the actual fair value that is expensed in each reporting period. Private companies with little or no historical employee forfeiture data may need to look to a comparable rate, such as the turnover rate at peer companies to determine a reasonable forfeiture rate (until you have your own sufficient historical data to use).
  5. Reporting Period: This is the time period in which you will report your expense. For example, if the company reports annually and the fiscal year end is 12/31, the reporting period for 2009 is 1/1/2009 – 12/31/2009.
  6. Expensing Method: You are able to calculate the amortization schedule for an option grant using one of the following three methods. Each of these methods use the forfeiture rate to discount (or “haircut”) the Actual Fair Value.
  1. Straight-Line: The straight-line expensing method is where you divide the projected fair value by the number of days in the requisite service period. Using this method expenses the same amount in each reporting period. The problem with using the straight-line method is that under many vesting schedules, you may not satisfy the requirement referred to above of expensing at least the portion of the fair value as the option has vested to date.
  2. FIN 28 (Accelerated Method): The accelerated expensing method treats each vesting tranche as a separate amortization period from grant date to vest date. This results in the expense being front-loaded, since expense from each vesting period is taken in the current reporting period. Although this typically satisfies the FASB requirement referred to above of expensing at least the portion of the fair value as the option has vested to date, it can have what some companies consider the negative impact of a much greater expense being taken in earlier years and a much lower expense in later years.
  3. Modified Straight-Line: The modified straight-line expensing method (which I recommend) is based on the straight-line expensing method, but adjusts for the requirement that you need to recognize at least the portion of the fair value as the option has vested to date. This results in a slightly higher expense in earlier periods, but ensures that you take enough expense under both graded and front-loaded option vesting schedules.Regardless of which method you use, if an option fully vests, you end up taking the same amount of expense over the entire service period.
  1. Projected Fair Value: The actual amount expected to be expensed each period is called the Projected Fair Value which is the Actual Fair Value reduced by the forfeiture rate. This value is generated through the creation of the amortization schedule.
  2. True-Up: At each reporting period, you can consider running a “true-up” of projected fair value based on actual forfeitures and actual vesting events. When adjusting for a true-up using the modified straight-line method, you recalculate the amortization schedule to determine how much should be expensed at the end of that reporting period. This adjustment results in:
  1. A credit entry for any expense taken for any options forfeited during the reporting period (options cancelled prior to vesting).
  2. A debit entry for any employees still with the company to account for (a) the amount that actually vested during the reporting period and (b) a portion of the next vesting tranche that is more likely to vest.

If you determined a reasonably accurate projected forfeiture rate, the true-up amount should typically be immaterial. If it is not, you should consider adjusting the forfeiture rate you use going forward. Also, keep in mind that when an option fully vests, you end up expensing the actual fair value for that grant regardless of the forfeiture rate you selected.

Just like when my one year old first started to crawl, it takes some assistance and a little trial and error before you understand how to generate an option’s amortization schedule. It is a complicated process and this short article is only able to provide an overview of the basics. The complexity in the process is the reason that so many companies turn to a more automated system that involves less management and manipulation of complex spreadsheets.

To see how an integrated equity management system can bring together stock plan administration, FAS 123R reporting, and equity compliance, sign up for a demonstration of Two Step Software’s online equity management system, Equity Focus.

If you have not yet read Part 1 on valuation, you may find it helpful. Otherwise, Part 3 will be posted shortly that discusses how to generate the financial statement disclosures of FAS 123R.

If you have any questions, feel free to contact me at jwright@twostep.com or post them in the comments below. If there are any areas where you would like more information, please let me know.

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2 Responses to FAS 123R – Part 2: Expensing Stock Options … Demystified

  1. Pingback: FAS 123R – Part 3: FAS 123R Reporting Disclosures … Clarified | Two Step Software, Inc.

  2. Pingback: FAS 123R – Part 1: Valuation and Black-Scholes Variables … Simplified | Two Step Software, Inc.

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