Accounting in the new Market
Intrinsic value is the difference between the market price of the stock and the option’s exercise price (the specified price at which the employee can purchase the stock) at the grant date (the date when the employee is awarded the option). Total compensation cost is determined at the grant date and allocated to the periods benefited by the employee’s services-the service period. The service period is usually the vesting period-the time between the grant date and the vesting date (the date when the employee controls the exercise of the stock option). 1
II. Fair Value Method
Using the fair value approach, total compensation expense is computed based on the fair value of the options that are expected to vest on the grant date. A company can deduct the “fair value” of an option as an expense at the time the option is granted, allocating the cost over the vesting period of the option. (The time of recognition is the same in both methods, only the valuation is different.) Fair value at the grant date is estimated by using an acceptable pricing model. An acceptable pricing model estimates option value based on the following factors which determine its underlying value: (1) Volatility of the underlying stock, (2) the expected life of the options, (3) the risk-free rate during the option life, and (4) the expected dividends during the option life. The Black-Scholes method is the most commonly used model in valuing options. 1
Black-Scholes Method
The Black-Scholes option pricing model, for which its originators won a
Nobel Prize in 1997, is indeed a powerful and useful tool. It values options
according to six factors. Four are known: the exercise price, the market price,
the current market rate of interest, and the term of the option. One is more-or-less known: dividends. For high tech companies, dividends can be safely set at zero. The last factor is the most difficult: the expected volatility of the shares. 2
Since FASB does not require the Black-Scholes method, just a method that meets the criteria for pricing models, that leaves the door open for companies to use different pricing models. Enter Coca-Cola. One of the first companies to announce plans to expense options, Coke plans to determine fair value by soliciting bids from at least two investment banks and averaging the result. The plan was devised by board member Warren Buffett. "There are a lot of decisions that need to be made when you apply Black-Scholes, and they are subjective," explains spokesperson Kari Bjorhus. "We felt it would be more fair and objective to ask third parties." 9
Issues related to calculating expense
The FASB strongly urges companies to use the fair value method, but almost no one does. Instead, they use intrinsic value (the difference between the grant price and the market price). This is almost always zero because [next page]