Objectives Overview Controversy Accounting Objectives Overview Controversy Accounting Treatment Lessons Learned Treatment Lessons Learned Greg Callow Greg Callow Matt Faulkner Matt Faulkner Dana Gies Dana Gies Mary Mumcuoglu Mary Mumcuoglu Marcel Nugent Marcel Nugent Tracey Weiler Tracey Weiler Management Compensation motivate employees to high levels of performance, help retain executives and allow for recruitment of new talent, base compensation on employee and company performance, maximize employee’s after-tax benefit and minimize employee’s after tax cost, and use performance criteria over which the employee has control. Stock Options Defined …securities issued by a company that carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price… Lessons Learned No longer reserved for executive suite Still popular, even after the dot-com crash Can be expensive to exercise Two common types of plans Nonqualified stock options Qualified, or “incentive” stock options (ISOs) It’s usually smart to hold options as long as you can There may be compelling reasons to exercise early Stock Options & Management Compensation Stock Options & Management Compensation
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Gain understanding of stock options Gain understanding of stock options and management compensationand management compensation
Recognize the differences between Recognize the differences between past and current accounting past and current accounting treatment of stock optionstreatment of stock options
Become familiar with stock option Become familiar with stock option implications as they relate to implications as they relate to employee and employeremployee and employer
Purpose:Purpose:– motivate employees to high levels of motivate employees to high levels of
performance,performance,– help retain executives and allow for help retain executives and allow for
recruitment of new talent,recruitment of new talent,– base compensation on employee and base compensation on employee and
company performance,company performance,– maximize the employee’s after-tax benefit and maximize the employee’s after-tax benefit and
minimize the employee’s after-tax cost, anminimize the employee’s after-tax cost, andd– use performance criteria over which the use performance criteria over which the
……securities issued by a companysecurities issued by a company that carry the right, but that carry the right, but not the obligation, to buy a certain amount of shares in not the obligation, to buy a certain amount of shares in
the company at a predetermined price…the company at a predetermined price…
The strike price is typically set near the market price of the The strike price is typically set near the market price of the stock on the day the option is grantedstock on the day the option is granted
Employees must typically wait a specified vesting period Employees must typically wait a specified vesting period before being allowed to exercise the option before being allowed to exercise the option
The idea behind stock options:The idea behind stock options: To motivate employees…increase performanceTo motivate employees…increase performance To offer uncapped potential gain through increased stock priceTo offer uncapped potential gain through increased stock price To allow companies to retain talent in the early yearsTo allow companies to retain talent in the early years To foster a culture of employee ownershipTo foster a culture of employee ownership To align incentives between the employees and shareholders To align incentives between the employees and shareholders
1.1. Focus remained on quarterly performance rather Focus remained on quarterly performance rather than on long termthan on long term
Were allowed to sell stock after exercising optionsWere allowed to sell stock after exercising options What do you think about amending option plans to What do you think about amending option plans to
require employees to hold their shares for a year or two require employees to hold their shares for a year or two after exercising them?after exercising them?
2.2. Tax laws allowed managements to manage Tax laws allowed managements to manage earnings by increasing the use of options instead earnings by increasing the use of options instead of cash wagesof cash wages
If a company wished to maintain its EPS growth rate If a company wished to maintain its EPS growth rate and they thought it might be difficult to do so, they and they thought it might be difficult to do so, they could implement new option programs thus reducing could implement new option programs thus reducing growth in cash wages. growth in cash wages.
The UglyThe Ugly Option abuse has 3 major adverse Option abuse has 3 major adverse
impacts:impacts:1.1. Oversized rewards given by servile Oversized rewards given by servile
boards to ineffective executivesboards to ineffective executives1.1. In earlier years, BODs allowed executives to In earlier years, BODs allowed executives to
exercise and sell stock with less restrictions exercise and sell stock with less restrictions than those placed on lower-level employeesthan those placed on lower-level employees
2.2. Repricing options rewards Repricing options rewards underperformers at the expense of the underperformers at the expense of the common shareholdercommon shareholder
1.1. Repricing “out of the money” options in order Repricing “out of the money” options in order to keep employees from leavingto keep employees from leaving
2.2. Who will reprice the shareholders’ shares?Who will reprice the shareholders’ shares?
3. Increases dilution risk as more 3. Increases dilution risk as more and more options are issuedand more options are issued
1.1. EPS dilution from an increase in EPS dilution from an increase in shares outstandingshares outstanding
2.2. Earnings reduced by increased interest Earnings reduced by increased interest expenseexpense
3.3. Management dilution – management Management dilution – management spending more time maximizing option spending more time maximizing option payout and financing stock repurchase payout and financing stock repurchase programs than running the businessprograms than running the business
Accounting TreatmentAccounting Treatment To Expense or Disclose?
Should employers expense stock option costs in calculating net income?
Employers already disclose the cost in the notes to the financial statements and must show the potential impact on earnings.
Expensing options significantly reduces EPS Companies can deduct for tax purposes GAAP doesn’t require expense of options
Study by Bear Stearns in ‘02 estimates that, had the fair value of stock options been expensed in 2001, aggregate diluted EPS for the S&P 500 would have been reduced 20%
Similarly, according to Standard & Poor’s, expensing options would reduce reported 2004 earnings among the S&P 500 by 7.4% while the effect on many technology firms would be much greater. For example, in an August 2, 2004, press release, Intel reported that its second-quarter 2004 profit would have decreased 17% if it had expensed its stock options
Pre 2002 – no standard under GAAPPre 2002 – no standard under GAAP Jan. 1 2002 - CICA introduced Jan. 1 2002 - CICA introduced
section 3870 (Canadian Standard): section 3870 (Canadian Standard): Fair value of the stock options is Fair value of the stock options is determined and recorded as determined and recorded as compensation expense over the compensation expense over the vesting period of the option - starting vesting period of the option - starting 20022002
Jan. 1 2004 – mandatory expense Jan. 1 2004 – mandatory expense for public companiesfor public companies
Impact to Cott Corp. & NortelImpact to Cott Corp. & Nortel
Cott’s NI before option Cott’s NI before option compensation was compensation was $6.14 M in ’02$6.14 M in ’02
Including the impact of Including the impact of options decreased NI options decreased NI to a loss of $2.36 M, a to a loss of $2.36 M, a decrease of ~140%decrease of ~140%
Nortel reported a net Nortel reported a net loss of $5.631 B in ’02loss of $5.631 B in ’02
Including the impact of Including the impact of options increased this options increased this loss to $7.13 billion, an loss to $7.13 billion, an impact of nearly 27% impact of nearly 27% or ~$1.5 Bor ~$1.5 B
Pre 1995 – choice was up to the company Pre 1995 – choice was up to the company Then in 1995, the initial proposal surfaced that Then in 1995, the initial proposal surfaced that
would require companies to expense the would require companies to expense the totaltotal fair fair value of options.value of options.
There was strong opposition. There was strong opposition.
1.1. Status quo continued and they had a choice: Status quo continued and they had a choice: 1.1. recognizing on the Income Statement or,recognizing on the Income Statement or,
2.2. disclosing in a footnotedisclosing in a footnote
2.2. Amortize total fair value over vesting period of the Amortize total fair value over vesting period of the stock options (SFAS 123 – Revised 2004)stock options (SFAS 123 – Revised 2004)
3.3. August 1August 1stst 2005, required to recognize as an 2005, required to recognize as an expense on the Income Statementexpense on the Income Statement
Current Regulations include: Current Regulations include:
1.1. Separate description of multiple plansSeparate description of multiple plans• where companies have > one stock-based where companies have > one stock-based
compensation plancompensation plan
2.2. Which options-pricing model is usedWhich options-pricing model is used• Including underlying assumptionsIncluding underlying assumptions
3.3. Number and weighted average exercise price of Number and weighted average exercise price of options:options:
• Outstanding at beginning and end of the yearOutstanding at beginning and end of the year• Granted during the yearGranted during the year• Exercised, forfeited or expired during the yearExercised, forfeited or expired during the year• Exercisable at the end of the yearExercisable at the end of the year
What potential solutions would What potential solutions would you propose?you propose?
Expensing is only one Expensing is only one part, we also need:part, we also need: ethical managementethical management governancegovernance controlscontrols disclosuredisclosure
““Expensing Options Solves Expensing Options Solves Nothing”, Nothing”, William William Sahlman. Sahlman. Harvard Harvard Business Review, Dec. ‘02Business Review, Dec. ‘02
Pre S.3870Pre S.3870 Intrinsic approach Intrinsic approach
Record expense as the amount that the Record expense as the amount that the market price exceeded the exercise price at market price exceeded the exercise price at its grant dateits grant date
Where market was not > exercise price, Where market was not > exercise price, companies were not required to record companies were not required to record impactimpact
Post S. 3870Post S. 3870 Fair value, using any methodFair value, using any method
Benefits from Benefits from stock options stock options are included in are included in employment employment income in year income in year in which they in which they are disposed are disposed
favourable to favourable to employeesemployees
Also popular Also popular with employers with employers because there because there is no immediate is no immediate cash cost cash cost