Group D Taylor Carson Nicholas Chow Michael Cheuk-Hei Yu

CICA Handbook Section 3870 Provides the guidelines for how to recognize, measure, and disclose stock based compensation Applies to transactions involving the granting of: Common Stock Stock Options Other Equity Instruments Incurs Liabilities

Key Definitions Employee Award Measurement Date Fair Value Stock Option

Recognition and Measurement For Non-Employees: Reciprocal transactions in which an enterprise acquires goods and services by granting equity instruments or by incurring liabilities to the supplier (other than an employee) in amounts based on the price of the enterprise's stock shall be accounted for based on the fair value of the consideration received, or the fair value of the equity instruments, or liabilities incurred, whichever is more reliably measurable For Employees: Equity instruments awarded to employees and the cost of the services received as consideration shall be measured and recognized based on the fair value of the equity instruments

Section 3870 Disclosure Rules Provide a description of the plan The number and weighted average exercise prices of options The weighted average grant-date fair value of options granted If the exercise price is different from the market price, the weighted averages of both should be disclosed Number and weighted average grant-date fair value of equity instruments other than options

Disclosure Rules (Cont’d) Description of the method and assumptions used to estimate the fair value of options Total compensation cost recognized in income Amounts charged or credited to contributed surplus Amounts credited to share capital Amounts receivable from employees The terms of significant modifications

A Study by Jianfeng Wu, Rungting Tu

CEO Stock Option Pay and R&D spending The study of behavioral agency perspective answers two questions: 1. How does CEO stock option pay influence long-term risky investment such as R&D? 2. What are the contextual factors that moderate such a linkage?

CEO stock option pay and R&D spending It is the CEO’s responsibility to make critical decisions about R&D resource allocation To encourage CEO’s risk-taking behaviour, they are granted stocks Stock ownership has a linear relationship with stock price and discourage executives from risk-taking decisions Conversely, stock option pay encourages managerial risk-taking behaviour

CEO stock option pay and R&D spending (cont’d) Under the same argument, CEO stock options positively influence a firm’s R&D investment for the following reasons: 1. Value of stock options may not necessarily materialize to actual wealth 2. CEO’s have to wait for several years to fully benefit their stock options 3. The role of stock options is distinct from that of stock ownership which encourages R&D spending

Moderating effects of slack resources and firm performance The CEO option pay-R&D spending relationship is contingent on two factors: Slack resources Firm performance

Slack Resources The case provides two theoretical perspectives on the effect of slack resources: The buffer argument The waste argument Buffer argument: believes that organization slack accumulates partly as a result of prior good performance Waste argument: believes that slack resources are wasteful and reflect managerial self-interest

Firm Performance If actual performance doesn’t meet the expected standard, top managers face pressure from shareholders and employees Therefore, they are forced to find immediate solutions Some argue that organizational search it motivated by poor performance while others argue that good performance leads to more search

Interaction between CEO stock option pay and firm slack To initiate new projects, the CEO has to consider two issues: 1. Activities such as acquisitions and R&D require huge investments 2. Extra resources are required to prevent the firm from downside risks and potential losses.

Interaction between CEO stock option pay and firm slack (cont’d) The existence of slack resources helps meet these two requirements The existence of slack resources provides CEOs with more resources to invest in R&D Slack resources buffer managers from immediate pressures for positive gains CEOs’ anticipated wealth from unexercised, positive- valued options remains safe

Interaction between CEO stock option pay and firm performance R&D investment has two basic characteristics: risky and future-oriented When firm performance is poor, top managers have pressure to search for immediate solutions When firm performance is good, slack resources accumulate and provides extra funding for R&D activities and buffers top managers from downside risks

A Study by Yuval Deutsch

Definitions and Effects Stock-Options R&D Intensity Outside Directors Risk-Averse, Risk-Neutral and Risk-Seeking

Purpose Study is being performed to enhance knowledge surrounding the effects of stock-option compensation for board members, specifically outside board members given the increase in stock-options From 1990 to 1996, the percentage of firms that included stock-options as part of director compensation rose from 17 to almost 80 percent

View on R&D Expenditure Involves a temporal trade-off of short-term financial performance for long-term performance gains Also involves an increase in firm risk, as R&D does not always turn into future increased revenues or margins

View on R&D Expenditure (cont’d) Increased risk and temporal trade-off can provide a conflict between managers and shareholders: Shareholders can diversify away the increased risk in hopes of higher pay-offs, whereas the manager is more likely to worry about the firm specific risk as they are risk-averse by assumption Due to mobility of managers, their time horizon may not be far enough into the future to invest in R&D

Role of the Board Important mechanism for limiting managers’ self-serving behaviour in situations of conflicting goals between shareholders and managers Outside members, while in theory more suitable for a board position due to their independence, also have pitfalls including not wanting to challenge the CEO and holding time-consuming positions with other firms May not want to challenge the CEO for purposes of being offered other or continued board positions, as well as potential decreased possibility for consulting contracts

Support of Stock-Based Compensation Offering directors equity aligns their goals better with those of the shareholders Initial findings included showing that equity compensation helps better protect shareholder interests One study showed that managers push to exclude stock-based compensation from directors’ compensation plans

Risk Characteristics Stock-options don’t necessarily need to be exercised, and therefore the agent’s value is more closely tied to the shareholders during increased value than decreased Stock-option value increases when the volatility of a firm’s value increases This leads to increased risk taking by directors due to the fact that they have less to lose than if stock pay were used and the increased value in potential volatility

Previous Board Compensation Theories Agency theory suggests that higher percentages of outside directors better aligns the firm direction with the desire of shareholders as inside members would be better aligned with the CEO Studies of the 80s and 90s actually showed the opposite effect, due to the fact that inside directors had more information and could better evaluate the CEO’s strategic decisions, whereas outside members would focus too intently on strict financial data, causing a lower interest in higher risk projects

Hypotheses of Deutsch 1. The higher outside directors’ stock-option compensation, the higher firms’ R&D intensity will be 2. The interaction between the percentage of outside directors on boards and the level of their stock- option compensation is positively related to firms’ R&D intensity

Results Hypothesis 1 is supported by the fact that stock-option compensation is positively and statistically significantly related to R&D Intensity in Deutsch’s study Hypothesis 2 is also supported by the results, but it was discovered that the intense shift from negative to positive correlation between outside board member percentage and R&D intensity occurs around stock- option compensation of $300,000 USD

Implications In line with agency theory, providing stock-option benefits to outside directors does in fact provide an incentive for outside directors to be more involved in the firm’s strategic decisions In particular, it will decrease directors’ aversion to risk, thus increasing potential investment in R&D and future firm value

Implications (cont’d) High representation of outside directors coupled with a sufficient stock-option compensation leads to the highest level of board alignment with shareholder interests Older negative correlations between outside board members and R&D Intensity were before stock-option compensation, and can now be explained by the lack of said compensation, aligning the studies with current agency theory

Implications (cont’d) Although there is increased R&D intensity associated with stock-option compensation, there has yet to be study regarding whether or not the effect on risk- aversion can be too great One use of R&D intensity in these studies is to measure the level of risk directors are willing to take, and there is an inherent possibility that over compensating this way could lead to risk-seeking directors, as opposed to less risk-averse (but still risk- averse directors)