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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Greg CallowMatt Faulkner Dana GiesMary Mumcuoglu Marcel NugentTracey Weiler Management Compensation motivate employees to high levels of performance, help retain executives and allow for recruitment of new talent, base compensation on employee and company performance, maximize employee’s after-tax benefit and minimize employee’s after tax cost, and use performance criteria over which the employee has control. Stock Options Defined …securities issued by a company that carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price… Lessons Learned No longer reserved for executive suite Still popular, even after the dot-com crash Can be expensive to exercise Two common types of plans Nonqualified stock options Qualified, or “incentive” stock options (ISOs) It’s usually smart to hold options as long as you can There may be compelling reasons to exercise early Stock options aren’t your only option for compensation Stock Options & Management Compensation
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Greg Callow Matt Faulkner Dana Gies Mary Mumcuoglu Marcel Nugent Tracey Weiler
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Agenda Learning Objectives Learning Objectives General Overview General Overview Controversy Controversy Accounting Treatment Accounting Treatment Lessons Learned Lessons Learned Questions Questions
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Learning Objectives Gain understanding of stock options and management compensation Gain understanding of stock options and management compensation Recognize the differences between past and current accounting treatment of stock options Recognize the differences between past and current accounting treatment of stock options Become familiar with stock option implications as they relate to employee and employer Become familiar with stock option implications as they relate to employee and employer
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Management Compensation Purpose: – motivate employees to high levels of performance, – help retain executives and allow for recruitment of new talent, – base compensation on employee and company performance, – maximize the employee’s after-tax benefit and minimize the employee’s after-tax cost, and – use performance criteria over which the employee has control.
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned How many of you have stock options in your company? How many of you would like to have stock options in your company?
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Types of Plans Direct Awards of Stock Direct Awards of Stock Compensatory Stock Option Plans (CSOPs) Compensatory Stock Option Plans (CSOPs) Employee Stock Option Plans (ESOPs) Employee Stock Option Plans (ESOPs) Stock Appreciation Rights Plan (SARs) Stock Appreciation Rights Plan (SARs) Performance-Type Plans Performance-Type Plans Incentive Stock Options – ISO Incentive Stock Options – ISO Nonqualified Stock Options - NQS Nonqualified Stock Options - NQS
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Stock Options Defined …securities issued by a company that carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price… The strike price is typically set near the market price of the stock on the day the option is granted The strike price is typically set near the market price of the stock on the day the option is granted Employees must typically wait a specified vesting period before being allowed to exercise the option Employees must typically wait a specified vesting period before being allowed to exercise the option
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Stock Option Motivations The idea behind stock options: To motivate employees…increase performance To motivate employees…increase performance To offer uncapped potential gain through increased stock price To offer uncapped potential gain through increased stock price To allow companies to retain talent in the early years To allow companies to retain talent in the early years To foster a culture of employee ownership To foster a culture of employee ownership To align incentives between the employees and shareholders of a company To align incentives between the employees and shareholders of a company
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Shareholders vs. Managers Long term growth Investment growth Seek what is in the best interests of the company Bonus based on short term results such as earnings growth Seek what is in the best interests of themselves Stock options attempt to better align interests of employees with shareholders by maintaining a long term growth potential
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned In Practice Closely-held companies often issue stock options Closely-held companies often issue stock options IPO driven IPO driven Public companies Public companies Some industries, it has become standard practice such as in high-tech Some industries, it has become standard practice such as in high-tech From 1997 to 2002, use of stock options in Canada more than doubled from 25% to 59%
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Can anyone think of the main reasons for what was good in theory, but ended up being bad in practice?
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned The Good vs. The Bad 1. Focus remained on quarterly performance rather than on long term Were allowed to sell stock after exercising options Were allowed to sell stock after exercising options What do you think about amending option plans to require employees to hold their shares for a year or two after exercising them? What do you think about amending option plans to require employees to hold their shares for a year or two after exercising them? 2. Tax laws allowed managements to manage earnings by increasing the use of options instead of cash wages If a company wished to maintain its EPS growth rate and they thought it might be difficult to do so, they could implement new option programs thus reducing growth in cash wages. If a company wished to maintain its EPS growth rate and they thought it might be difficult to do so, they could implement new option programs thus reducing growth in cash wages.
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned The Ugly Option abuse has 3 major adverse impacts: Option abuse has 3 major adverse impacts: 1. Oversized rewards given by servile boards to ineffective executives 1. In earlier years, BODs allowed executives to exercise and sell stock with less restrictions than those placed on lower-level employees 2. Repricing options rewards underperformers at the expense of the common shareholder 1. Repricing “out of the money” options in order to keep employees from leaving 2. Who will reprice the shareholders’ shares?
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned The Ugly cont… 3. Increases dilution risk as more and more options are issued 1. EPS dilution from an increase in shares outstanding 2. Earnings reduced by increased interest expense 3. Management dilution – management spending more time maximizing option payout and financing stock repurchase programs than running the business
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned The Ugly cont… Options only align the interest of employees with shareholders if they are structured so that flipping is eliminated and the same vesting and selling rules apply to every employee, whether C-level or janitor
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Accounting Treatment To Expense or Disclose? Should employers expense stock option costs in calculating net income? Employers already disclose the cost in the notes to the financial statements and must show the potential impact on earnings. Expensing options significantly reduces EPS Companies can deduct for tax purposes GAAP doesn’t require expense of options Study by Bear Stearns in ‘02 estimates that, had the fair value of stock options been expensed in 2001, aggregate diluted EPS for the S&P 500 would have been reduced 20% Similarly, according to Standard & Poor’s, expensing options would reduce reported 2004 earnings among the S&P 500 by 7.4% while the effect on many technology firms would be much greater. For example, in an August 2, 2004, press release, Intel reported that its second- quarter 2004 profit would have decreased 17% if it had expensed its stock options
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Accounting Treatment cont… Jan 1 2002Jan 1 2004 Expensing – voluntary Disclosure - mandatory Fair value or disclose Expensing – mandatory for public co.’s ASB followed the US approach using the fair-value-based accounting method. In 2002, CICA Handbook Section 3870 set standards for the recognition, measurement and disclosure of stock-based compensation Pre 2002Jan 1 2005 No standard under GAAP S. 3870 a) scholes b) binomial Expensing – mandatory for private co.’s Aug 1 2005 Expensing – mandatory for US co.’s US FSAB regulates
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Canada Pre 2002 – no standard under GAAP Pre 2002 – no standard under GAAP Jan. 1 2002 - CICA introduced section 3870 (Canadian Standard): Fair value of the stock options is determined and recorded as compensation expense over the vesting period of the option - starting 2002 Jan. 1 2002 - CICA introduced section 3870 (Canadian Standard): Fair value of the stock options is determined and recorded as compensation expense over the vesting period of the option - starting 2002 Jan. 1 2004 – mandatory expense for public companies Jan. 1 2004 – mandatory expense for public companies Jan. 1 2005 – mandatory expense for private companies Jan. 1 2005 – mandatory expense for private companies
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Impact to Cott Corp. & Nortel Cott’s NI before option compensation was $6.14 M in ’02 Cott’s NI before option compensation was $6.14 M in ’02 Including the impact of options decreased NI to a loss of $2.36 M, a decrease of ~140% Including the impact of options decreased NI to a loss of $2.36 M, a decrease of ~140% Nortel reported a net loss of $5.631 B in ’02 Nortel reported a net loss of $5.631 B in ’02 Including the impact of options increased this loss to $7.13 billion, an impact of nearly 27% or ~$1.5 B Including the impact of options increased this loss to $7.13 billion, an impact of nearly 27% or ~$1.5 B
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned SFAS. No. 123 (US Standard) Pre 1995 – choice was up to the company Pre 1995 – choice was up to the company Then in 1995, the initial proposal surfaced that would require companies to expense the total fair value of options. Then in 1995, the initial proposal surfaced that would require companies to expense the total fair value of options. There was strong opposition. There was strong opposition. 1. Status quo continued and they had a choice: 1. recognizing on the Income Statement or, 2. disclosing in a footnote 2. Amortize total fair value over vesting period of the stock options (SFAS 123 – Revised 2004) 3. August 1 st 2005, required to recognize as an expense on the Income Statement
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned IFRS 2 (International Standard) Requires all entities to recognize share based compensation as an expense Requires all entities to recognize share based compensation as an expense Fair value method is applied Fair value method is applied Improves comparability of financial reporting around the world Improves comparability of financial reporting around the world
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Disclosure Current Regulations include: 1. Separate description of multiple plans where companies have > one stock-based compensation plan where companies have > one stock-based compensation plan 2. Which options-pricing model is used Including underlying assumptions Including underlying assumptions 3. Number and weighted average exercise price of options: Outstanding at beginning and end of the year Outstanding at beginning and end of the year Granted during the year Granted during the year Exercised, forfeited or expired during the year Exercised, forfeited or expired during the year Exercisable at the end of the year Exercisable at the end of the year
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned What potential solutions would you propose? Expensing is only one part, we also need: ethical management ethical management governance governance controls controls disclosure disclosure “Expensing Options Solves Nothing”, William Sahlman. Harvard Business Review, Dec. ‘02
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Accounting Treatment cont… Real Debate centered around value Real Debate centered around value Fair value – option pricing models require many assumptions, all of which vary over time Fair value – option pricing models require many assumptions, all of which vary over time Black-Scholes Model Black-Scholes Model Timing – when the actual expense is incurred Timing – when the actual expense is incurred When awarded? When awarded? When exercised? When exercised? The requirement of stock option expensing is the most controversial standard ever proposed in Canada and in the US (FASB).
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Valuation Pre S.3870 Pre S.3870 Intrinsic approach Intrinsic approach Record expense as the amount that the market price exceeded the exercise price at its grant date Record expense as the amount that the market price exceeded the exercise price at its grant date Where market was not > exercise price, companies were not required to record impact Where market was not > exercise price, companies were not required to record impact Post S. 3870 Post S. 3870 Fair value, using any method Fair value, using any method Black-Scholes Black-Scholes Binomial Binomial
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Taxation Benefits from stock options are included in employment income in year in which they are disposed Benefits from stock options are included in employment income in year in which they are disposed favourable to employees Also popular with employers because there is no immediate cash cost Also popular with employers because there is no immediate cash cost favourable to employers Taxation
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Future direction Eliminate options altogether Eliminate options altogether Direct award of stock would eliminate the value debate Direct award of stock would eliminate the value debate Direct award of cash Direct award of cash To reduce the dilutive effect, implement stock repurchase programs To reduce the dilutive effect, implement stock repurchase programs
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Weaknesses Still Still not focus employees on long-term financial goals Little corporate governance Outside the scope of management controls Not immediate benefits
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Strengths Motivates and retains employees Cash is infused into c Cash is infused into companies when employees exercise their options Great upside (gain) benefit potential
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned It’s time to play Family Feud…
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Lessons Learned No longer reserved for executive suite No longer reserved for executive suite Still popular, even after the dot-com crash Still popular, even after the dot-com crash Can be expensive to exercise Can be expensive to exercise Two common types of plans Two common types of plans Nonqualified stock options Nonqualified stock options Qualified, or “incentive” stock options (ISOs) Qualified, or “incentive” stock options (ISOs) It’s usually smart to hold options as long as you can It’s usually smart to hold options as long as you can There may be compelling reasons to exercise early There may be compelling reasons to exercise early Stock options aren’t your only option for compensation Stock options aren’t your only option for compensation
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Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Questions?
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