Share-Based Payments

Share-based payments are transactions wherein an entity acquires goods or services by issuing shares
(stock), share options, or other equity instruments. It also includes transactions with an employee or
supplier wherein the entity incurs a liability that is based on the price of the entity’s shares or that will
be settled using equity shares.

1. There are two important distinctions for applying the rules for share-based payments:

a. Is the share-based payment to employees or nonemployees?

b. Is the share-based payment considered equity or a liability?

2. Share-based payments to nonemployees. Share-based payments to nonemployees for goods and

services are measured at the fair value of the equity instruments or the fair value of the goods and
services, whichever is more reliable.

3. Share-based payments to employees. Share-based payments to employees are measured based on

the fair value-based method. The cost of the services is measured at the grant-date fair value of the
equity instruments issued, or the fair value of the liability incurred. Employee service cost is based on
fair value net of any amount the employee pays or is obligated to pay for the instrument.

a. The fair value of an equity share option is measured based on the observable market price of
an option with the same or similar terms and conditions, or estimated using an option-pricing
model.

(1) If it is not possible to estimate fair value at the grant date, the compensation cost is
measured using the intrinsic value at the end of each reporting period, and final compensation
cost is measured at the settlement date.

(a) The intrinsic value is the difference between the market value of the stock and the
price the employee must pay.
b. Compensation cost for share-based employee compensation classified as equity is amortized
on a straight-line basis over the requisite service period.

(1) The requisite service period is the period in which the employee is required to provide
services, which is usually the vesting period.

(2) The service inception date is the beginning of the requisite service period.

(3) Firms must estimate the number of forfeitures that will occur.

(a) No compensation cost is recognized if an employee forfeits shares because a service

or performance condition is not met.

(b) However, if an employee renders the requisite service and the share option expires or
is unexercised, previously recognized compensation cost is not reversed.
 c. Share-based payments may also be classified as liabilities.

(1) Puttable shares are considered liabilities if the repurchase feature allows the employee to
avoid bearing the risks and rewards for a reasonable period (six months or more).

(2) The measurement date for liability instruments is the settlement date; therefore, share-
based payments are remeasured at the end of each reporting period.

(3) Compensation cost is the change in fair value of the instrument from one period to the
next.
Share-Based Payments
Classified as Equity Classified as Liability
When to measure Grant-date fair value of Each reporting period
equity instrument Final measurement on
settlement date
How to measure Observable market price of Fair value of liability
option with same or similar incurred
terms
OR
Estimate using option
pricing model
OR
Intrinsic value at end of
each reporting period if no
market price or estimate
can be determined
(net of amounts that
employee must pay)
How to allocate Straight-line over requisite Straight-line over requisite
compensation service period service
expense period

d. If an option-pricing model (such as Black-Scholes model) is used, the option-pricing model should
consider the following variables:

(1) Current price of the underlying stock

(2) Exercise price of the option
(3) Expected life of the option
(4) Expected volatility of the underlying stock
(5) Expected dividends on the stock
(6) Risk-free interest rate during the expected option term
(a) The resulting fair value shall be applied to the number of options expected to vest (based on the
grant date estimate) or the total number of options issued.
EXAMPLE
To illustrate the recognition and measurement of stock compensation expense, suppose ABC
Corporation (a public company) establishes an employee stock option plan on January 1, year 1. The
plan allows its employees to acquire 10,000 shares of its $1 par value common stock at $52 per share,
when the market price is also $52. The options may not be exercised until five years from the grant
date. The grant-date fair value of an option with similar terms and conditions is $8.62.

Accounting for Stock-Based Compensation

Calculation of Compensation Cost

Fair Value of Option at grant-date $ 8.62 × Number of options 10,000 = Deferred comp. expense
$86,200

The journal entry to recognize the deferred compensation expense in Year 1 is shown below.

Deferred comp. expense 86,200

Stock options outstanding 86,200

During each of the next five years which is the requisite service period, compensation expense is
recognizes as follows:

Compensation expense 17,240

Deferred comp. expense 17,240

When the option is exercised, cash is received and stock is issued as reflected in the following entry
(assume exercise after the five-year period):

Cash 52,000 (option price)

Stock options outstanding 86,200
Common stock 10,000 (par)
Additional paid-in capital 128,200 (plug)