1111111 Stock-based compensation Under SFAS No. 123 (Rev. 2004) Prepared by Teresa Gordon.

1111111

Stock-based compensation

Under SFAS No. 123 (Rev. 2004)

Prepared by Teresa Gordon

Two kinds of option plans

NoncompensatoryCompensatory Classified as Liability or Equity See chart on next slide

Two types of awardsAwards classified as liability

Awards classified as equity

Remeasured at fair value on each balance sheet date until the award is settled

Measured at fair value at the grant date and not subsequently remeasured

Award is classified as liability if the entity can be required under any circumstances to settle the option or similar instrument by transferring cash or other assets

Award is classified as equity if it is an equity instrument and the company cannot be required to settle the option in cash under any circumstances.

Awards classified as liability Awards classified as equity

Remeasured at fair value on each balance sheet date until the award is settled

Measured at fair value at the grant date and not subsequently remeasured

Measurement date = settlement date Measurement date = grant date (generally)

Award is classified as liability if the entity can be required under any circumstances to settle the option or similar instrument by transferring cash or other assets

Award is classified as equity if it is an equity instrument and the company cannot be required to settle the option in cash under any circumstances.

Options that permit broker-assisted cashless exercise does not result in liability classification if

1. Cashless exercise requires a valid exercise

2. The employee is the legal owner of the shares

Provisions to provide cash to meet minimum statutory withholding requirements are also okay

Non-Compensatory Plans1. Discount from market price no more than

cost that would have been incurred in public offering

Safe harbor rule: discount ≤ 5% of market price

2. Substantially all employees may participate on an equitable basis

3. There are no option features other than:a. No more than 31 days after price is fixed to

enrollb. Purchase price is based solely on market price

at purchase dateAlso, employees can cancel participation before

purchase date and get a refund

Compensatory Plan

Any plan that fails to satisfy the three criteria

Note: Incentive stock options under the tax code will not necessarily be noncompensatory under GAAP However, there would be no need for

deferred taxes because the employee would not be taxed and the employer does not get a tax deduction

Terminology

Measurement date and grant date are often (but not always) the same

Measurement date - The date at which the equity share price and other pertinent factors, such as expected volatility, that enter into measurement of the total recognized amount of compensation cost for an award of share-based payment are fixed.Grant date - The date at which an employer and an employee reach a mutual understanding of the key terms and conditions of a share-based payment award.

Approval by shareholders or board of directors may be required The grant date for an award of equity instruments is the date

that an employee begins to benefit from, or be adversely affected by, subsequent changes in the price of the employer’s equity shares.

FASB 123 – Fair Value Method

FASB requires the fair value methodThe compensation cost (to be amortized to expense) is determined by an option pricing model. Factors in models include:

Market price and exercise price Risk free interest rate Expected volatility of stock prices Expected dividend on stock Number of years until options expire

Stock Option Plans

Information for following examples: 1,000 options for common stock $3 par market price $8 option price $6 Service period required is four years.Grant date

Service Period

Exercise Period

Fair value per share - $6

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Fair Value Method

Compensation Expense = $1,500 per year spread over 4 years So we make the following journal entry

each year:

Compensation expense 1,500 APIC – stock options O/S

1,500

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Fair Value Method

Upon exercise: all options

Cash (1,000 sh x $6) 6,000

Paid in Capital, stock options 6,000

Common Stock

3,000

APIC – Common Stock 9,000

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Stock Option Plans & Deferred Taxes

If the market price upon exercise is substantially greater than the market price on the day of grant it will result in significant unrecorded compensation to the employeeThe employee pays tax on the difference between option price and market price on the day the option is exercised There are some fine points which we will ignore

for simplicity in working problems

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Stock Option Plans & Deferred Taxes

The employer gets a tax deduction based on the difference between the option price and the market price on the day the options are exercised.This is probably different than what was provided in deferred tax.Excess benefits are credited to APIC

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When people quit . . .

We “undo” the recognition of compensation expense related to options that FAIL TO VEST because of service or performance conditions

Credit compensation expense, and debit APIC – stock options outstanding

Failure to perform service (Intrinsic Value Method:

Paid in Capital, stock options 2,000

Compensation Expense 2,000

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When vested options are not exercised

Perhaps market price < option price No one will exercise the options When they expire, the balance is

transferred to APIC – expired options Compensation is NOT reversed

Expiration of unexercised VESTED stock options:

Paid in Capital, stock options 2,000

Paid in Capital, expired options

2,000

Complications

Requisite service periodEstimating turnoverDeferred taxes

Performance conditionsMarket conditionsUsing an option pricing model Nonpublic companies

Grant date

Service Period

Exercise Period

Measurement Date =

Awards classified as liabilities

Compensation is estimated at each balance sheet date through settlement

Grant date

Service Period

Exercise Period

Measurement Date

Stock appreciation rights (SARs)

Sometimes the plan gives the employee CASH for the increase in the price of the stock between grant date and the measurement dateIn this case, a liability is created and APB Opinion 25 and FASB 123 accounting is exactly the same but ONLY for nonpublic companiesEstimated fair values at each balance sheet date required for public companies

Example – SARs - NONPUBLIC

Mary will receive the difference between the current stock prices ($10) and the stock price that exists when she exercises her 1,000 SARs. She cannot exercise the options for 2 years. The options expire 5 years from the grant date

End of year 1, price = $21

50% earned1,000 SARs * ($21-20) = $1,000 potential liabilityRecognized now = 50% of $1,000

Compensation expense $500

SARs Liability $500

End of year 2, price = $23

100% earned1,000 SARs * ($23-20) = $3,000 potential liabilityRecognized now = 100% of $3,000 less $500 already booked

Compensation expense $2,500

SARs Liability $2,500

End of year 3, price = $18

100% earned1,000 SARs * ($18-20) = $0 valueOn books = $3,000

SARs Liability $3,000

Compensation expense $3,000

During of year 4, price = $22

Mary exercises SARS1,000 SARs * ($22-20) = $2,000 valueLiability on books = $0

Compensation expense $2,000

SARs liability$2,000

SARs Liability $2,000

Cash $2,000

Equity or Liability Awards

The measurement date may not be the grant date The number of options to be issued may not

be certain until the level of achievement of a performance condition is known

Grant date

Service Period

Exercise Period

Measurement Date

Major difference between FAS123R and FAS133

We re-value derivatives under FAS133 based on current economic conditionsUnder FAS123 the value of equity awards is determined (generally) on the grant date and does not change after that date Note that liability awards are re-valued

like derivatives under FAS133

Requisite Service Period

Explicit service period: Stated in the terms of a share-based payment award. Implicit service period: Not explicitly stated but inferred from an analysis of the terms and other facts and circumstances. Derived service period: A service period for an award with a market condition that is inferred from the application of certain valuation techniques used to estimate fair value.

Multiple service periods

“Or” conditions – requisite service period is the shortest of the possible periods“And” conditions – requisite service period is the longest of the possible periods The complications are likely when there is both

a service condition and one or more performance conditions and maybe a market condition specified or implied by the terms of the award

Modification of terms

When an equity award is modified, it must be remeasured

Recall that liability awards are automatically remeasured on reporting dates

If the new award has greater fair value than the old award immediately before the modification, the excess fair value is recognized as compensation expense