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

Two kinds of option plans Noncompensatory Compensatory Classified as Liability or Equity  See chart on next slide

Non-Compensatory Plans 1. 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 enroll b. Purchase price is based solely on market price at purchase date Also, 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

FASB 123(R) – Fair Value Method FASB requires the fair value method The 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 are expected to be exercised Additional guidance provided in SAB 107 (April 2005)

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.

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

Compensatory Awards Classified as liabilityClassified 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. Modified by FSP FAS 123(R)-4 (Feb 3, 2006)

Refer to FSP FAS 123(R)-4 A cash settlement feature that can be exercised only upon the occurrence of a contingent event that is outside the employee’s control would NOT require classification as a liability award

Complications Requisite service period Estimating turnover Deferred taxes Modification of terms Performance conditions Market conditions Nonpublic companies Grant date Service Period Exercise Period Measurement Date =

Types of Conditions Service condition Performance condition Market condition

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

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

21 Fair Value Method Compensation Expense = $1,500 per year spread over 4 years So we make the following journal entry each year: Compensation expense1,500 APIC – stock options O/S 1,500

21 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

22 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 employee The employee pays tax on the difference between option price and market price on the day the option is exercised

22 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

23 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 Paid in Capital, stock options 2,000 Compensation Expense 2,000

24 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 period Estimating turnover Deferred taxes Performance conditions Market conditions Using 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 date In this case, a liability is created and APB Opinion 25 and FASB 123 accounting is exactly the same but ONLY for nonpublic companies Estimated fair values at each balance sheet date required for public companies

Example – SARs - NONPUBLIC Mary will receive the difference between the current stock prices ($20) 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% earned 1,000 SARs * ($21-20) = $1,000 potential liability Recognized now = 50% of $1,000 Compensation expense$500 SARs Liability$500

End of year 2, price = $23 100% earned 1,000 SARs * ($23-20) = $3,000 potential liability Recognized now = 100% of $3,000 less $500 already booked Compensation expense$2,500 SARs Liability$2,500

End of year 3, price = $18 100% earned 1,000 SARs * ($18-20) = $0 value On books = $3,000 SARs Liability$3,000 Compensation expense$3,000

During of year 4, price = $22 Mary exercises SARS 1,000 SARs * ($22-20) = $2,000 value Liability on books = $0 Compensation expense$2,000 SARs liability$2,000 SARs Liability$2,000 Cash$2,000

Example – SARs - PUBLIC Mary will receive the difference between the current stock prices ($20) 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. The initial fair value is $3

End of year 1, price = $21, FV=$ % earned 1,000 SARs * $2.50 = $2,500 potential liability Recognized now = 50% of $1,250 Compensation expense$1,250 SARs Liability$1,250

End of year 2, price = $23, FV=$4 100% earned 1,000 SARs * $4 = $4,000 potential liability Recognized now = 100% of $4,000 less $1,250 already booked Compensation expense$2,750 SARs Liability$2,750

End of year 3, price = $18, FV= $ % earned 1,000 SARs * $2) = $2,000 value On books = $4,000 SARs Liability$2,000 Compensation expense$2,000

During of year 4, price = $22 Mary exercises SARS Fair value = intrinsic value at exercise 1,000 SARs * ($22-20) = $2,000 value Liability on books = $2,000 SARs Liability$2,000 Cash$2,000 Note that the cash received by the employee is the same whether it is a public or a nonpublic company

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 conditions Under 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