1 Stock-based compensation Under SFAS No. 123 (Rev. 2004) Prepared by Teresa Gordon 12 th Edition KWW should be correct

2 Two kinds of option plans Noncompensatory  Rules on Slide 3 Compensatory Classified as Liability or Equity  See chart on Slide 4

3 Non-Compensatory Plans 1. Option exercise amount very close to market price Safe harbor rule: discount ≤ 5% of market price 2. Substantially all employees may participate on an equitable basis 3. Short enrollment period 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

4 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)

5 FASB 123 – 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 expire

6 Conditions in Awards Conditions may impact vesting, exercisability, exercise price, and other features that affect the fair value of an award Service conditions Performance conditions Market conditions

7 Recognition of expense When services are provided Generally grant date until the options can be exercised (the exercise date) Also called “the service period” Grant date Service Period Exercise Period

8 Awards classified as equity Compensation is measured at each the measurement date and allocated to service period Grant date Service Period Exercise Period Measurement Date =

9 Awards classified as liabilities Compensation is estimated at each balance sheet date through settlement Grant date Service Period Exercise Period Measurement Date

10 Complications Requisite service period Estimating turnover Deferred taxes Modification of terms Performance conditions Market conditions Using an option pricing model Nonpublic companies Grant date Service Period Exercise Period Measurement Date?

11 Examples 1. Award classified as equity 2. Award classified as debt

12 Award Classified as Equity Information for example: 1,000 options for common stock $3 par market price $8 and option price $8 Service condition=work for company for 4 years Grant date Service Period Exercise Period Fair value per share - $6 Go to Excel

13 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

14 When vested options are not exercised Perhaps market price < option price  “Out of the money” 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

15 Example 2 – SARs (Go to Excel) Mary works for a nonpublic company. 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 Grant date Service Period Exercise Period Expiration Date

16 Example 3 Same facts as Example 2 but the company is publicly traded Therefore, they must use the fair value method and estimate fair value on each balance sheet date. So this makes the SARS quite a bit more complicated!