1. 1 Stock-based compensation Under SFAS No. 123 (Rev. 2004) Prepared by Teresa Gordon {With IFRS comparison at the end}

2. 2

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

4. 4 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

5. 5 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)

6. 6 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

7. 7 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

8. 8 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

9. 9 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 =

10. 10 Awards classified as liabilities Compensation is estimated at each balance sheet date through settlement Grant date Service Period Exercise Period Measurement Date

11. 11 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?

12. 12 Examples 1. Award classified as equity 2. Award classified as debt (nonpublic) 3. Award classified as debt (public company)

13. 13 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 Example 1

14. 14 21 Award Classified as Equity Compensation Expense = 1,000 options * $6 = $6,000 Spread over required service period $6,000/4 = $1,500 per year So we make the following journal entry each year: Compensation expense1,500 APIC – stock options O/S 1,500

15. 15 21 Award Classified as Equity Upon exercise: all options Cash (1,000 sh x $8) 8,000 Paid in Capital, stock options 6,000 Common Stock ($3 * 1,000) 3,000 APIC – Common Stock 11,000

16. 16 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

17. 17 24 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

18. 18 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

19. 19 End of year 1, price = $11 50% earned 1,000 SARs * ($11-10) = $1,000 potential liability Recognized now = 50% of $1,000 Compensation expense$500 SARs Liability$500

20. 20 End of year 2, price = $13 100% earned 1,000 SARs * ($13-10) = $3,000 potential liability Recognized now = 100% of $3,000 less $500 already booked Compensation expense$2,500 SARs Liability$2,500

21. 21 End of year 3, price = $8 100% earned 1,000 SARs * ($8-10) = $0 value Liability on books = $3,000 SARs Liability$3,000 Compensation expense$3,000

22. 22 During of year 4, price = $12 Mary exercises SARS 1,000 SARs * ($12-10) = $2,000 value Liability on books = $0 Compensation expense$2,000 SARs liability$2,000 SARs Liability$2,000 Cash$2,000

23. 23 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!

24. Share-based Compensation IFRS 2 vs FAS 123R versus

25. Comparing the standards IFRSUS GAAP Grant date is when agreement is reached All employee awards are treated as compensatory Payroll taxes are accrued as employees earn the compensation Grant date is the earlier of mutual understanding, or date when employee begins to provide services Compensatory and noncompensatory have separate rules Payroll taxes are recorded at exercise date (or vesting date for restricted stock)

26. Comparing the standards IFRSUS GAAP Deferred tax assets recognized when share options have current intrinsic value Adjustments made based on current stock prices This increases the volatility of the impact on profit and loss Deferred taxes recognized based on grant date fair value as compensation is recognized Deferred tax asset is not revalued as stock prices change

27. Equity Awards vs. Liability Awards IFRSUS GAAP IFRS classification is based on the method of expected settlement (cash or shares) IF recipient has a choice, classification is based on the expected settlement Fixed monetary amount to be paid in varying number of shares = equity award If the award CAN BE settled in cash, it is classified as a liability award If recipient has CHOICE, it is assumed to be cash and therefore a liability award Fixed monetary amount to be paid in varying number of shares = liability award

28. Recognition of Awards IFRSUS GAAP Recognized over the related period of employee service Explicit Implicit No “derived” – so in rare cases, the recognition period will be different Recognized over the related period of employee service Explicit Implicit Derived

29. Recognition for Plans with Graded Vesting IFRSUS GAAP Must treat each tranche as a separate award May treat each tranche as a separate award Recognize compensation separately over the period of each separate tranche May use straight-line method for the entire award Recognize compensation over the period covered by all the tranches