What is the difference between intrinsic value and fair value methods for stock option compensation expense?

This is a foundational topic in share-based compensation accounting. Let me walk through both methods and explain why fair value became the required approach.

Intrinsic Value Method (APB 25 — Superseded)

Intrinsic value = Market price of stock − Exercise price of the option at the grant date

If a company grants options with an exercise price equal to the market price at the grant date (at-the-money options), the intrinsic value is zero — meaning NO compensation expense would be recognized.

This was the problem. Companies could grant millions of dollars' worth of options and record zero expense, as long as the exercise price equaled the grant-date market price.

Fair Value Method (ASC 718 / IFRS 2 — Current Requirement)

Fair value is determined using an option pricing model (typically Black-Scholes or a binomial/lattice model) at the grant date. The fair value captures:

• Current stock price
• Exercise price
• Expected term of the option
• Risk-free rate
• Expected volatility
• Expected dividends

Worked Example — Pelican Software:

Pelican grants 50,000 options to employees on January 1, 2026:

• Stock price at grant: $35.00
• Exercise price: $35.00
• Expected term: 5 years
• Risk-free rate: 4.2%
• Expected volatility: 40%
• Expected dividends: 1.5%

Intrinsic value at grant date = $35 − $35 = $0

Under the old APB 25 method: Total compensation expense = $0

Fair value (using Black-Scholes) = $12.80 per option

Under ASC 718: Total compensation expense = 50,000 × $12.80 = $640,000

If the vesting period is 3 years, annual expense = $640,000 / 3 = $213,333

Why Fair Value Won:

The intrinsic value method dramatically understated compensation costs. During the tech bubble, companies issued massive option grants with zero reported expense, misleading investors about true compensation costs. This contributed to the push for ASC 718 (effective 2006) and IFRS 2.

Key Exam Points:

1. Fair value is measured once — at the grant date. Subsequent changes in stock price do NOT affect the compensation expense (for equity-settled awards).
2. Expense is recognized over the vesting/service period using straight-line or accelerated methods.
3. Forfeitures — companies estimate expected forfeitures and adjust the expense accordingly (ASC 718) or can elect to recognize forfeitures as they occur.
4. IFRS 2 — largely consistent with ASC 718 for equity-settled awards.

For more option valuation topics, explore our CFA Level I question bank.