FAS 123, "Accounting for Stock-Based Compensation," was issued by the FASB in October 1995, and established financial accounting and reporting standards for stock-based employee compensation plans.

It defined a "fair value" based method of accounting for an employee stock option and encouraged all companies to adopt that method of accounting. Under the "fair value" based method, compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. Here is a summary of FAS 123. Or a copy of FAS 123 is available for purchase online.

Ernst & Young LLP has prepared a white paper on "Accounting for Stock Compensation, available on the FEI web site under "Financial Reporting," dated July 30, 2002. This white paper provides a "List of Adopters" on page 3, a "Summary of Statement 123" on pages 3 and 4, "Determining Fair Value" on pages 4 and 5, "Expense Recognition" on page 5, "Liabilities" on page 6, and "Settlements of Awards" on page 6.

KPMG has also provided a "defining issues" white paper on "Accounting for Stock-Based Compensation," dated July 2002.

FAS 123 does not endorse a specific valuation model to value employee stock options. Most companies now use the Black-Scholes Option Pricing Model to value stock options for their pro forma disclosures of net income and earnings per share now permitted by FAS 123. However, Black-Scholes was developed to value publicly traded call options in a liquid market, not non-transferable employee stock options subject to vesting requirements and forfeiture.

For a better understanding of the Black-Scholes Option Pricing Model, Kevin Rubash of Bradley University provides a basic academic discussion. Click on "The Black-Scholes Model." This will explain the assumptions used to value stock options.

For help in understanding how to use the Black-Scholes model in applying FAS 123, see the following sites:

• KPMG has an article on "Accounting for Stock-Based Compensation" on FEI's Web site
• CFO.com had an article in May by Robert Willens of Lehman Brothers titled "Stock Options: Easy as FAS No. 123" . If you scroll down, you will see related articles and related sites.
• As an example, E-Trade provides a "Practical Implementation of FAS 123".
• If you want a better understanding of the Black-Scholes Option Pricing Model, Kevin Rubash of Bradley University provides a basic academic discussion of Black-Scholes. Click on "The Black and Scholes Model."
• Another discussion is found here.
• Jerry Marlow provides an animated tutorial. He also offers "Option Pricing: Black-Scholes Made Easy" for $79.95.
• For a related article, see "Coke to Treat Options as the Real Thing" from CFO.com. According to this article: "Coke said it intends to use quotations from independent financial institutions to determine the fair value of the stock options granted. The option value to be expensed will be based on the average of the quotations received from the financial institutions to buy or sell Coca-Cola shares under the identical terms of the stock options granted."
• A good source of information on employee stock options is the National Center for Employee Ownership, the NCEO.

An article from the Research Foundation Web site on Underwater Options