1. Stock Options Compensation RCJ Chapter 15 (842-854)

2. Paul Zarowin2 Key Issues 1.Intrinsic Value method 2.Fair Value method 3.Grant date 4.Exercise price 5.Vesting period 6.Expiration period 7.Expected life 8.Volatility 9.Repricing 10.Footnote disclosures 11.Pro-forma NI 12.Option activity 13.Options outstanding and exercisable

3. Paul Zarowin3 Employees ’ Stock Options Stock options have become a very pervasive vehicle in compensation of employees. Especially in the high growth industries, such as hi-tech. Offer employees the opportunity to purchase the firm’s common stock at a price (the exercise price) that is lower than the market price.

4. 4 Key Terms and Variables variables in italics must be estimated; all others are observable Grant date - date at which the options are granted to the employee (usually the end of the year) Exercise price - price at which employee can buy the stock; the exercise price is usually set equal to the market price at the grant date Vesting period - period over which the employee first becomes eligible to exercise the options Expiration period - period after which the options lapse (i.e., can no longer be exercised) expected life - expected time from grant date to exercise (must be $vesting period and #expiration period) volatility - variance of the firm’s stock price Note:FV is a function of (exercise price, volatility, expected life, stock price, market interest rate)

5. Paul Zarowin5 Example of a Stock Option On Jan. 1 st 1998 IBM grants one of its employee an option to purchase 2,000 stocks: Vesting period of 3 years Exercise price $55 Duration 10 years Employee exercises option in 2002 How much money will the employee earn upon exercise of this option?

6. Price on Jan 2002 is $120 Employee earns: ($120-$55) x 2,000 =$130,000  Did the option have value on Jan. 1 st 1998 (when price was $55)? Grant date Option vested Option exercised

7. Paul Zarowin7 In,Out and At the Money Options Options can be: “ In the money ”, i.e., the exercise price is below the current stock price. “ Out of the money ”, i.e., the exercise price is above the current stock price. “ At the money ”, i.e., the exercise price is the same as the current stock price. Employees ’ stock options are typically granted at the money.

8. Paul Zarowin8 Accounting for Employees ’ Stock Options Firms have choice of 2 methods: 1.IV (Intrinsic Value) Method (APB #25) – method most firms use to account for stock options: only recognize compensation expense if exercise price < market price @ grant date must show footnote disclosure of pro-forma NI and EPS under the fair value method (and the option pricing method used along with the method ’ s relevant assumptions) 2.FV (Fair Value) Method (SFAS #123) – recognize compensation expense @ grant date equal to the FV of the options at that date

9. Paul Zarowin9 Intrinsic Value Method 1. grant @ 12/31 ex price = mkt price 3. Don ’ t exercise 2. Exercise 3a. Reprice (reset ex price) 3b. Lapse

10. Paul Zarowin10 Intrinsic Value Method (cont ’ d) 1. No compensation expense if exercise price  market price; no accounting event, so no entry 2. Entry is: DR CR Cash xxx C/S xxx where xxx is the amount of cash collected (i.e., the exercise price * # of shares)  note: option exercise is a balance sheet event, a stock issuance at the exercise price, (no compensation expense)  employee’s taxable income= #shares*(market price - exercise price); firm tax deduction is same 3a. Firm recognizes compensation expense = # shares * (change in exercise price) 3b. No accounting event, no entry

11. Paul Zarowin11 Intrinsic Value Method (cont ’ d) key points: 1.there is no effect on NI (no compensation expense) except 3a (repricing) 2.real cost is dilution (reduction of EPS due to extra shares outstanding) or cash outflow (to repurchase shares to counteract dilution) correct exercise entry to show economic cost of options: DRCash #shares*ex price DRCompensation expense #shares (mrk price-ex price) CR C/S #shares*mkt price@exercise Ex. E15-11, 15

12. Paul Zarowin12 IV vs. FV Methods IV MethodFV Method (a)(b) (c)(d) ex pr < mkt pr @ grant ex pr  mkt pr @ grant ex pr < mkt pr @ grant ex pr  mkt pr @ grant 1. grantcomp exp = #shrs*(mkt pr-ex pr) No eventComp exp - Determined by option pricing model Same as (C) APC 2. exercisecashSame as (A)Cash=cash receivedSame as (C) C/SAPC=offset CR from 1 3. lapseNo eventSame as (A) 4. repriceComp exp =#shrs*(ch in ex pr) Same as (A) Comp exp =  in FV of options Same as (C) APC

13. Paul Zarowin13 Stock Option Footnote Disclosures 1. Existing options at B/S date a. outstanding options (usually grouped by range of ex prices) exercise price # outstanding Wt avg remaining life Wt avg ex price b. repeat for options currently exercisable 2. Option activity during the year # wt avg ex price options @ beginning of year + options granted - options exercised actual figures go here - options forfeited = options @ end of year 3. Option pricing method used and the method ’ s assumptions note: IV firms show pro-forma NI and EPS under FV method Ex. P15-6, C15-1

14. Paul Zarowin14 Pure Accrual IV Method to Account for Stock Options (use options ’ FMV to measure contingent liability and deferred compensation asset) 1.recognize options ’ FMV at grant date as a contingent liability and deferred compensation asset 2.increase (or decrease) contingent liability and deferred compensation accounts as options ’ FMV changes 3.amortize deferred compensation to compensation expense over specified service period 4.at exercise, extinguish contingent liability and record share issue at its MV 5.if lapse, extinguish contingent liability (if any value remains) and record increase in O/E (for uncompensated services received)

15. Paul Zarowin15 Pure Accrual IV Method – JEs (entries 1, 4, and 5 are transactions; entries 2 and 3 are adjustments @ EOY) DR CR amount 1. deferred compensation (B/S) contingent liability (B/S) options ’ FMV 2. same as #1 (or reverse) change in FMV 3. compensation expense (I/S) def. compensation (B/S) amort. amount 4. cash (exercise price) C/S (market price) contingent liab.(mktpr – expr) 5. contingent liability APC remaining, unexercised value

16. Paul Zarowin16 Modified Accrual IV Method to Account for Stock Options (don ’ t know options ’ FMV) (use difference between market price and exercise price to measure contingent liability and deferred compensation asset) 1.no entry at grant date if mkt. price = exercise price 2.recognize contingent liability and deferred compensation assets as stock price rises above exercise price; 2a. increase (or decrease) contingent liability and deferred compensation accounts as stock price changes 3.amortize deferred compensation to compensation expense over specified service period 4.at exercise, extinguish contingent liability and record share issue at its MV 5.if lapse, extinguish contingent liability (if any value remains) and record increase in O/E (for uncompensated services received)

17. Paul Zarowin17 Modified Accrual IV – JEs (entries 4 and 5 are transactions; others are adjustments @ EOY) DR CR amount 1. no entry if mkt price = exercise price 2. def. compensation(B/S) contingent liability (B/S) excess of mktpr - expr 2a. same as #1 (or reverse) change in mktpr 3. compensation exp (I/S) def. compensation (B/S) amort. amount 4. cash (exercise price) C/S (market price) contingent liab (mktpr – expr) 5. contingent liability APC remaining, unexercised value

18. Paul Zarowin18 Modified Accrual IV, JEs - Cont ’ d correction entry* DR CR Deferred compensation asset xxx contingent liability xxx xxx = (market price – exercise price) x # of outstanding in the money options; often referred to as option overhang, amount of loss incurred if all outstanding options were exercised at current price; conservative liability estimate, because it ignores price rise; can discount it for probability of non-exercise and tax benefits of exercise * overstates O/E, because it doesn ’ t account for amortized Deferred compensation asset, which is difficult to estimate