CEP Financial Analysis & Reporting 2 — Questions and Answers
Question 1: Under ASC 718, which method is required for estimating the fair value of employee stock options granted by public companies?
- Intrinsic value method
- Option-pricing model such as Black-Scholes or lattice model (Correct answer)
- Book value method
- Discounted cash flow of expected dividends
Correct answer: Option-pricing model such as Black-Scholes or lattice model
ASC 718 requires public companies to use an option-pricing model (e.g., Black-Scholes or a lattice/binomial model) to estimate fair value of stock options.
Question 2: A company grants RSUs with a cliff vesting schedule. How is the stock-based compensation expense recognized over the vesting period?
- All at grant date
- Ratably (straight-line) over the requisite service period (Correct answer)
- Only upon settlement
- Accelerated front-loading using the graded method
Correct answer: Ratably (straight-line) over the requisite service period
For awards with cliff vesting, straight-line recognition over the requisite service period is the default method under ASC 718.
Question 3: Which input to the Black-Scholes model reflects the market's expectation of future stock price volatility?
- Risk-free interest rate
- Expected dividend yield
- Expected volatility (Correct answer)
- Expected term
Correct answer: Expected volatility
Expected volatility captures how much the stock price is expected to fluctuate and is a key input to option fair value under Black-Scholes.
Question 4: When an employee forfeits unvested stock options before the vesting date, what is the accounting treatment?
- Previously recognized expense is reversed; cumulative expense reflects only vested awards (Correct answer)
- No adjustment is made; all expense already recognized is retained
- A deferred tax asset is immediately written off
- The grant-date fair value is reclassified to equity
Correct answer: Previously recognized expense is reversed; cumulative expense reflects only vested awards
Forfeitures result in reversal of previously recognized expense so that cumulative compensation cost equals the fair value of awards that actually vest.
Question 5: What effect does an increase in expected stock option term have on the Black-Scholes option value?
- Decreases value because of higher risk
- Increases value because there is more time for the stock to appreciate (Correct answer)
- Has no effect on value
- Decreases value because dividends reduce the stock price
Correct answer: Increases value because there is more time for the stock to appreciate
A longer expected term gives the option more time for the underlying stock to move favorably, increasing its fair value.
Question 6: For ESPP offerings with a look-back provision, what is the maximum discount under Section 423 that companies can offer without triggering tax at grant?
- 10%
- 15% (Correct answer)
- 20%
- 25%
Correct answer: 15%
Section 423 qualified ESPPs may offer up to a 15% discount from the lower of the stock price at the beginning or end of the offering period.
Question 7: When stock-based compensation is included in a company's income statement, which line item is typically NOT affected?
- Cost of revenues
- Research and development expense
- Interest expense (Correct answer)
- Selling, general and administrative expense
Correct answer: Interest expense
Stock-based compensation is an operating expense allocated across functional categories (COGS, R&D, SG&A) but does not affect interest expense, which is a financing cost.
CEP Financial Analysis & Reporting 2
Under ASC 718, which method is required for estimating the fair value of employee stock options granted by public companies?