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Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
Stock Based Compensation
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Stock Based Compensation

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  • 1. STOCK-BASED COMPENSATION PLANS Employee compensation plans frequently include stock-based awards. These may be outright awards of shares, stock options, or cash payments tied to the market price of shares. Sometimes only key executives participate in a stock benefit plan. Typically, an executive compensation plan is tied to performance in a strategy that uses compensation to motivate its recipients. Some firms, including Travelers Insurance, pay their directors entirely in shares. Actual compensation depends on the market value of the shares. Obviously, that’s quite an incentive to act in the best interests of shareholders. Although the variations of stock-based compensation plans are seemingly endless, each shares common goals. Whether the plan is a stock award plan, a stock option plan, a stock appreciation rights (SARs) plan, or one of the several similar plans, the goals are to provide compensation to designated employees, while sometimes providing those employees with some sort of performance incentive. Likewise, our The accounting objective is to record compensation expense goals in accounting for each of these plans are the same for each – (1) to determine the over the periods in which value of the compensation and (2) to expense that compensation over the periods in related services are performed. which participants perform services. The issue is not trivial. The median total compensation of chief executives of the 350 largest U.S. businesses, including salary, bonuses, gains from the exercise of stock options, long-term incentive payouts and the value of restricted stock at the time of grant, was $3,093,000 in 1997. Stock Award Plans Executive compensation sometimes includes a grant of shares of stock. Usually, such shares are restricted in such a way as to provide some incentive to the recipient. Typically, restricted stock award plans are tied to continued employment. In a restricted stock plan, shares actually are awarded in the name of the employee, although the Usually, restricted shares are company might retain physical possession of the shares. The employee has all rights subject to forfeiture if the of a shareholder, subject to certain restrictions or forfeiture. Ordinarily, the shares are employee doesn’t remain with subject to forfeiture by the employee if employment is terminated within some the company. specified number of years from the date of grant. The employee usually is not free to sell the shares during the restriction period and a statement to that effect often is inscribed on the stock certificates. These restrictions give the employee incentive to remain with the company until rights to the shares vest. The compensation associated with a share of restricted stock (or nonvested stock) is the market price of an unrestricted share of the same stock. This amount is accrued as compensation expense over the service period for which participants receive the shares, usually from the date of grant to when restrictions are lifted (the vesting date). 1 This is demonstrated in Illustration 18-3. 1 Restricted stock plans usually are designed to comply with Tax Code Section 83 to allow employee compensation to be nontaxable to the employee until the year the shares become “substantially vested,” which is when the restrictions are lifted. Likewise, the employer gets no tax deduction until the compensation becomes taxable to the employee. © Spiceland and Sepe, INTERMEDIATE ACCOUNTING , IRWIN
  • 2. Chapter 18 Employee Benefit Plans 2 Illustration 18-3 Restricted Stock Award Under its restricted stock award plan, Universal Communications grants 5 Plan million of its $1 par common shares to certain key executives at January 1, 2003. The shares are subject to forfeiture if employment is terminated within four years. Shares have a current market price of $12 per share. January 1, 2003 No entry Calculate total compensation expense: $12 fair value per share The total compensation is the x 5 million shares awarded market value of the shares ($12) = $60 million total compensation times 5 million shares. The total compensation is to be allocated to expense over the 4-year service (vesting) period: 2003 - 2006 $60 million ÷ 4 years = $15 million per year December 31, 2003, 2004, 2005, 2006 ($ in millions) Compensation expense ($60 million ÷ 4 years)............................... 15 The $60 million is accrued to Paid-in capital – restricted stock............................................ 15 compensation expense over the 4-year service period. December 31, 2003 Paid-in capital – restricted stock (5 million shares at $12)........... 60 When restrictions are lifted, Common stock (5 million shares at $1 par)................................ 5 Paid-in capital – restricted stock Paid-in capital – excess of par (to balance).............................. 55 is replaced by Common stock and Paid-in capital – excess of par. Once the shares vest and the restrictions are lifted, Paid-in capital – restricted stock is replaced by Common stock and Paid-in capital – excess of par. Additional Consideration An alternative way of accomplishing the same result is to debit “deferred compensation” for the full value of the restricted shares ($60 million in the Illustration) on the date they are granted: Deferred compensation (5 million shares at $12)..................................... 60 Common stock (5 million shares at $1 par).......................................... 5 Paid-in capital – excess of par (to balance)..................................... 55 If so, deferred compensation is reported as a reduction in shareholders’ equity resulting in a zero net effect on shareholders’ equity. Then, deferred compensation is credited when compensation expense is debited over the service period. Just as in Illustration 18-3, the result is an increase in both compensation expense and shareholders’ equity each year over the vesting period. The amount of the compensation is measured at the date of grant – at the market price on that date. Any market price changes that might occur after that don’t affect the total compensation. If restricted stock is forfeited because, say, the employee quits the company, related entries previously made would simply be reversed. This would result in a decrease in compensation expense in the year of forfeiture. The total compensation, adjusted for the forfeited amount, is then allocated over the remaining service period.
  • 3. Chapter 18 Employee Benefit Plans 3 Stock Option Plans Michael Spindler, chief executive of Apple Computer, reaped hefty profits: Using options, he bought the stock at about $26 and sold it for roughly $46, taking in $2.39 million.2 More commonly, employees aren’t actually awarded shares, but rather are given the option to buy shares in the future. In fact, options have become an integral part of the total compensation package for key officers of most medium and large companies. 3 As with any compensation plan, the accounting objective is to report compensation expense during the period of service for which the compensation is given. EXPENSE – THE GREAT DEBATE Stock option plans give employees the option to purchase (a) a specified number of shares of the firm's stock, (b) at a specified price, (c) during a specified period of time. One of the most heated controversies in standard-setting history has been the debate over the amount of compensation to be recognized as expense for stock options. At issue is how the value of stock options is measured, which for most options determines whether any expense at all is recognized. Conceptually, several ways to measure the compensation are possible. For example, the fair value of the services being compensated seem an appealing measure, but is difficult to determine objectively. Historically, options have been measured at their “intrinsic values” – the simple difference between the market price of the shares and the option price at which they can be acquired. For instance, an option that permits an employee to buy $25 stock for $10 has an intrinsic value of $15. However, plans in which the exercise price equals the market value of the underlying stock at the date of grant (which describes most executive stock option plans) have no intrinsic value and therefore result in zero compensation when measured this way, even though the fair value of the options can be quite significant. About half of the chief executives of the largest U. S. companies cashed in stock options in 1995 for a median gain of over $600,000. In 1992, Walt Disney Chairman Michael Eisner exercised enough stock options to realize a pretax profit of $126.9 million from selling 3.45 million shares. To many, it seems counterintuitive to not recognize compensation expense for plans that routinely provide executives with a substantial part of their total compensation. This is where the controversy ensues. In 1993, the FASB issued an Exposure Draft of a new standard that would have required companies to measure options at their After lengthy debate, the FASB fair values at the time they are granted and to expense that amount over the consented to encourage, rather appropriate service period. To jump straight to the punch line, the FASB bowed to than require, that the fair value public pressure and agreed to withdraw the requirement before it became a Standard. of options be recognized as expense. The FASB consented to encourage, rather than require, that fair value compensation be recognized as expense. Companies are permitted to continue accounting under APB Opinion 25 (the intrinsic value method referred to in the previous paragraph).4 Companies which choose to ignore the FASBs recommendation to recognized fair value compensation as expense on the income statement are required instead to provide essentially the same information in disclosure notes.5 Before we move to the details of the two alternative approaches to accounting for fixed stock options, it’s important to look back at what led the FASB to first propose fair value accounting and later rescind that proposal. 2 Diane Abt, “Apple Officials Sell Shares in Computer Firm,” BLOOMBERB BUSINESS NEWS, September 11, 1995. 3 In a recent survey of 600 corporations, 572 companies disclosed the existence of stock option plans. AICPA, ACCOUNTING TRENDS AND TECHNIQUES, 1995. 4 “Accounting for Stock Issued to Employees,” Opinions of the Accounting Principles Board No. 25, (New York: AICPA, 1972). 5 “Accounting For Stock-Based Compensation,” Statement of Financial Accounting Standards No. 123, (Stamford Conn.: FASB, 1995).
  • 4. Chapter 18 Employee Benefit Plans 4 Although the FASB had included reconsideration of existing stock option accounting on its agenda since 1984, it took intense pressure from the public, the SEC, and Congress to accelerate the project. As the 1990s began, the public was becoming increasingly aware of the enormity of executive compensation in general and compensation in the form of stock options in particular. The lack of accounting for this compensation was apparent, prompting the SEC to encourage the FASB to move forward on their stock option project. Even Congress got into the fray when, in 1992, a bill was introduced that would legislate that firms would report compensation expense based on the fair value of options. Motivated by this encouragement, the FASB issued its Exposure Draft in 1993. The real disharmony began then. Opposition to the proposed Standard was broad and vehement; and that perhaps is an understatement. Critics based their opposition on one or more of three objections: Criticisms of the FASB’s 1. Options with no intrinsic value at issue have zero fair value and should not give Requirement to Expense rise to expense recognition. This argument carried probably the least weight in Option Compensation the deliberations. The FASB, and even some critics of the proposal, were adamant that options provide valuable compensation at the grant date to recipients. 2. It is impossible to measure the fair value of the compensation on the grant date. The contention of these critics was that employee stock options usually can’t be traded in the marketplace and thus don’t have readily determinable market prices. The FASB argued vigorously that value can be approximated, though, using one of several option pricing models. These are statistical models that use computers to incorporate information about a company’s stock and the terms of the stock option to estimate the options’ fair value. We might say the FASB position is that it’s better to be approximately right than precisely wrong. 3. The proposed Standard would have unacceptable economic consequences. Essentially, this argument asserted that requiring this popular means of compensation to be expensed would cause companies to discontinue the use of options. Predicted effects ranged from undue penalties on middle-level managers, to stifling the growth of the technology industry and other growth companies, to impeding the recovery of the economy itself. The opposition included corporate executives , auditors,6 members of Congress,7 and the SEC.8 Ironically, the very groups that provided the most impetus for the rule change initially – the SEC and Congress – were among the most effective detractors in the end. The only group that offered much support at all was the academic community, and that was by-and-large non-vocal support. In reversing its decision, the FASB was not swayed by any of the specific arguments of any opposition group. Dennis Beresford, chair of the FASB at the time, indicated that it was fear of government control of the standard-setting process that prompted the Board to modify its position. The Board remained steadfast that the proposed change was appropriate. In backing away from its original proposal, the FASB did not completely abandon its position on option accounting. Instead, it decided to encourage, rather than require, expensing of the fair value of option compensation in the income statement. Companies that choose to continue accounting under APB Opinion 25 must still follow fair value accounting to comply with enhanced disclosure requirements. The disclosures are designed to allow investors and creditors to compare companies that choose the elective accounting approach and those that do not. So, even though the vast majority of companies do not expense option compensation, it’s important that we be familiar with the elective approach. 6 All of the “Big Six” CPA firms lobbied against the proposal. 7 Senator Lieberman of Connecticut introduced a bill in Congress that if passed would have forbidden the FASB from passing a requirement to expense option compensation. 8 One of the SEC’s commissioners wrote an editorial in opposition to the proposal: J. Beese, Jr., “A Rule that Stunts Growth,” The Wall Street Journal, February 8, 1994, p. 18.
  • 5. Chapter 18 Employee Benefit Plans 5 Prior to 2002, only two companies – Boeing and Winn-Dixie – reported stock option compensation expense at fair value. However, in 2002 public outrage mounted amid the high-profile accounting scandals at Enron, WorldCom, Tyco, and others. Some degree of consensus emerged that greed on the part of some corporate executives contributed to the fraudulent and misleading financial reporting at the time. In fact, many were pointing to the proliferation of stock options as a primary form of compensation as a culprit in fueling that greed. Renewed interest surfaced in requiring stock option compensation to be reported in income statements. At least partly in response to this public sentiment, Coca-Cola in 2002 announced it would begin reporting the fair value of its stock options as an expense. Perhaps seeing the “writing on the wall,” other companies soon followed suit. The next section describes the fair value approach. RECOGNIZING THE FAIR VALUE OF OPTIONS (THE ELECTIVE FAIR VALUE APPROACH ) Companies are encouraged, but not required, to estimate the fair value of stock The fair value of a stock option options on the grant date. This requires the use of one of several option pricing can be determined by models. These statistical models assimilate a variety of information about a employing a recognized option company’s stock and the terms of the stock option to estimate the options’ fair value. pricing model. The model should take into account the: Variables in an Option exercise price of the option Pricing Model expected term of the option current market price of the stock expected dividends expected risk-free rate of return during the term of the option expected volatility of the stock Option-pricing theory, on which the pricing models are based, is a topic explored in depth in finance courses and is subject to active empirical investigation and development. The total compensation as estimated by the options’ fair value is reported as compensation expense over the period of service for which the options are given. The service period is the vesting period in Illustration 18-4.
  • 6. Chapter 18 Employee Benefit Plans 6 Illustration 18-4 Stock Option Plan - The At January 1, 2003, Universal Communications grants options that permit key Elective Fair Value executives to acquire 10 million of the company’s $1 par common shares within the Approach next 8 years, but not before December 31, 2006 (the vesting date). The exercise price is the market price of the shares on the date of grant, $35 per share. The fair value of the options, estimated by an appropriate option pricing model, is $8 per option. January 1, 2003 No entry Calculate total compensation expense: $ 8 estimated fair value per option x 10 million options granted Fair value is estimated at the = $80 million total compensation date of grant. The total compensation is to be allocated to expense over the 4-year service (vesting) period: 2003 - 2006 $80 million ÷ 4 years = $20 million per year December 31, 2003, 2004, 2005, 2006 ($ in millions) Compensation expense ($80 million ÷ 4 years)............................... 20 The value of the award is Paid-in capital – stock options................................................. 20 expensed over the service period for which the Forfeitures compensation is provided. If previous experience indicates that a material number of the options will be forfeited before they vest (due to employee turnover or violation of other terms of the options), it’s permissible, but not required, to adjust the fair value estimate on the grant date to reflect that expectation. For instance, if a forfeiture rate of 4% is expected, the Unanticipated forfeitures are estimated total compensation would be 96% of $80 million. treated as a change in estimate, so the effect is a reduction in If no forfeitures had been anticipated, but material forfeitures occur later, amounts current and future expense, not previously expensed would not be altered. Instead, Paid-in capital - stock options previously recorded expense. would be reduced by the fair value of options forfeited times the fraction previously expensed. The offsetting credit is to compensation expense, resulting in a decrease in compensation expense in the year of forfeiture. Then, the remaining total compensation, adjusted for the value of forfeited options, would be allocated over the remaining service period. When Options Are If half the options in Illustration 18-4 (five million shares) are exercised on July 11, Exercised 2006, when the market price is $50 per share, the following journal entry is recorded: Recording the exercise of July 11, 2006 ($ in millions) options is not affected by the Cash ($35 exercise price x 5 million shares)........................................... 175 market price on the exercise Paid-in capital - stock options (1/2 account balance)......................... 40 date. Common stock (5 million shares at $1 par per share)..................... 5 Paid-in capital – excess of par (to balance)...................................... 210 Notice that the market price at exercise is irrelevant. Changes in the market price of underlying shares do not influence the previously measured fair value of options. If options that have vested expire without being exercised, the following journal entry When Unexercised is made (assuming none of the options in our illustration were exercised): Options Expire
  • 7. Chapter 18 Employee Benefit Plans 7 “Paid-in capital - stock options” becomes “Paid-in capital - ($ in millions) expiration of stock options” Paid-in capital – stock options (account balance).............................. 80 when options expire without Paid-in capital – expiration of stock options ............................. 80 being exercised. In effect, we simply rename the paid-in capital attributable to the stock option plan. Compensation expense for the four years’ service, as measured on the measurement date, is not affected. TAX REASONS FOR HOW OPTION PLANS ARE STRUCTURED It is common for the option price to be equal to the market price at the date of grant as it is in the preceding illustration. One important reason is the ability to avoid expensing compensation when the elective fair value approach is not chosen. Another reason is that this is one requirement for a plan to qualify as an “incentive stock option Tax treatment favors the plan” under the Tax Code. There are other requirements, but they are unimportant to executive in an incentive stock our discussion here. Under an incentive plan, the recipient pays no tax at the time of option plan. the grant or when the options are exercised. Instead, the tax on the difference between the exercise price and the market price at the exercise date isn’t paid until any shares acquired are subsequently sold. On the other hand, the company gets no tax deduction at all. Hewlett Packard provides an example of an incentive plan in Graphic 18-10. Graphic 18-10 Incentive Stock Options – Incentive Compensation Plans (in Part) Hewlett Packard The company has three principal stock option plans .... All plans permit options granted to qualify as Incentive Stock Options under the Internal Revenue Code. Since an incentive plan provides no tax deduction, it has no The exercise price of a stock option is generally equal to the fair market value of the deferred tax consequences. company's common stock on the date the option is granted. An incentive plan offers favorable tax treatment to the executive; but a nonqualified plan offers favorable tax treatment to the employer. With a nonqualified plan the employee cannot delay paying tax. The tax that could be deferred until the shares are sold under an incentive plan must be paid at the exercise date under a nonqualified plan. However, the employer is permitted to deduct the difference Tax treatment favors the employer in a nonqualified stock between the exercise price and the market price at the exercise date. Since tax option plan. asset is treatment favors the employer in a nonqualified stock option plan, why are the vast A deferred tax recognized now for the future majority of options structured as incentive plans? There are two reasons. tax savings from the tax deduction when the options are Reasons Options  The favorable tax treatment incentive plans provide executives allows companies exercised. Usually Are Structured to use the plans to attract and retain quality management personnel. As Incentive Plans  Due to Tax Code requirements, incentive plans typically offer an exercise price equal to the market price on the grant date. The market price usually exceeds the exercise price in a nonqualified plan. This difference allows companies to elect not to report compensation expense for an incentive plan; whereas a nonqualified plan requires earnings to be reduced by compensation expense. We discuss this next. If the eventual tax savings exceeds the deferred tax asset, the difference is recognized as ADDITIONAL CONSIDERATION equity. Tax Consequences of Stock-Based Compensation Plans If the eventual tax savings is less In Illustration 18-4 we ignored the tax effect. To illustrate the effect on taxes, let’s assume than the deferred tax asset, the Universal Communications’ income tax rate is 40%. difference is recognized as a reduction in either tax expense or previously recognized equity from the same source.
  • 8. Chapter 18 Employee Benefit Plans 8 Case 1. Recall from our earlier discussion that with an incentive plan, the employer receives no tax deduction at all. If Universal’s plan qualifies as an incentive plan, the company will receive no tax deduction upon exercise of the options and thus no tax consequences. Case 2. On the other hand, if we assume the plan does not qualify as an incentive plan, Universal will deduct the difference between the exercise price and the market price at the exercise date. Recall from Chapter 16 that this creates a temporary difference between accounting income (for which compensation expense is recorded currently) and taxable income (for which the tax deduction is taken later upon the exercise of the options). Under FASB 123, we assume the temporary difference is the cumulative amount expensed for the options. The following entries would be recorded on the dates shown: December 31, 2003, 2004, 2005, 2006 ($ in millions) Compensation expense ($80 million ÷ 4 years)............................................ 20 Paid-in capital – stock options........................................................ 20 Deferred tax asset (40% x $20 million)......................................................... 8 Income tax expense........................................................................... 8 The after-tax effect of on earnings is thus $12 million each year. If all of the options (ten million shares) are exercised in April, 2006: Cash ($35 exercise price x 10 million shares)...................................................... 350 Paid-in capital - stock options (account balance)....................................... 80 Common stock (10 million shares at $1 par per share)............................... 10 Paid-in capital – excess of par (to balance).................................................... 420 a. Options exercised when the tax benefit exceeds the deferred tax asset: If the market price is $50 per share: Income taxes payable ([$50 - 35] x 10 million shares x 40%)............................ 60 Deferred tax asset (4 years x $8 million)................................................. 32 Paid-in capital - tax effect of stock options (remainder)................... 28 b. Options exercised when the tax benefit is less than the deferred tax asset: If the market price is $40 per share: Income taxes payable ([$40 - 35]x 10 million shares x 40%)............................. 20 Income tax expense or Paid-in capital - tax effect of stock options* (remainder).................................................................. 12 ..........................................................................Deferred tax asset (4 years x $8 million) 32 * This treatment is consistent with a provision of SFAS 109 that requires the tax effect of an increase or decrease in equity (Paid-in capital – stock options, in this case) be allocated to equity.9 ** Paid-in capital - tax effect of stock options is debited only if that account has a sufficient credit balance from previous transactions in which the tax benefit exceeded the deferred tax asset. The tax consequences of all non-qualifying stock options, including those for which companies choose to account for options in accordance with APB Opinion 25, as well as restricted stock plans also are accounted for in the manner demonstrated above. RECOGNIZING THE INTRINSIC VALUE OF OPTIONS (THE ALTERNATE INTRINSIC VALUE APPROACH ) Learning objective 5 As pointed out in a previous discussion, most companies are adamantly opposed to Explain and implement the alternate expensing the fair value of options. As you might expect, most choose not to adopt the intrinsic value approach to elective fair value approach. These companies continue to account for options in accounting for stock compensation plans. accordance with APB Opinion 25 issued in 1972. By this approach, the value of fixed options is measured at the grant date in an amount equal to their “intrinsic values” rather than their fair values. Intrinsic value is simply the difference between the An option that permits an employee to buy $25 stock for market price of the shares and the exercise price at which they can be acquired. In $10 has an intrinsic value of $15. 9 “Accounting for Income Taxes,” Statement of Financial Accounting Standards No. 109, (Norwalk, Conn.: FASB, 1992), par. 36(C).
  • 9. Chapter 18 Employee Benefit Plans 9 other words, it is the benefit the holder of an option would realize by exercising the option and immediately selling the underlying stock. Market Value Equals Exercise Price An option whose exercise price equals or exceeds the market price of the underlying stock has zero intrinsic value. This was the situation in Illustration 18-4. Under the An option whose exercise price equals the market price of the APB Opinion 25 alternate approach, then, no compensation would be recorded for the underlying stock has zero options described in the illustration. Although the financial statements would be intrinsic value. unaffected by the existence of options whose exercise price equals or exceeds the market price, accompanying disclosure notes would report essentially the same information as would have been provided in the financial statements if the elective fair value approach is followed. As a result, companies opting to forego the elective fair value approach still must make the same fair value calculations [Illustration 18-4] as companies electing that approach. In fact, one required disclosure is pro forma (as if) net income and earnings per share determined as if the elective method had been applied in the financial statements. The objective of the enhanced disclosures is to permit comparability among companies regardless of which method they choose. Market Value Exceeds Suppose the options described in Illustration 18-4 were structured so they did have Exercise Price intrinsic value on the grant date. This would have been the case if Universal’s shares had a market value on that date of, say, $37. [Remember, the exercise price was $35.] We make that assumption in Illustration 18-5. Illustration 18-5 Market Value Exceeds At January 1, 2003, Universal Communications grants options that permit key Exercise Price executives to acquire 10 million of the company’s $1 par common shares within the (Nonqualifying Options) next 8 years, but not before December 31, 2006 (the vesting date). The exercise price is $35 and the market price of the shares $37 per share on the date of grant. January 1, 2003 No entry Calculate total compensation expense: $37 market value per share (35) exercise price $ 2 intrinsic value per option Under the alternative intrinsic x 10 million options granted value approach, compensation is recorded only when an = $20 million intrinsic value of award option’s market price exceeds its exercise price. The total compensation is to be allocated to expense over the 4-year service (vesting) period: 2003 - 2006 $20 million ÷ 4 years = $5 million per year December 31, 2003, 2004, 2005, 2006 ($ in millions) The intrinsic value of the Compensation expense ($20 million ÷ 4 years)............................... 5 options is expensed over the Paid-in capital – stock options................................................. 5 service period for which the compensation is provided. Compensation is recorded only to the extent of intrinsic value. However, in addition to their intrinsic value, the fair value of options also include a “time value” due to the fact that (a) the holder of an option does not have to pay the exercise price until the option is exercised and (b) the market price of the underlying stock may yet rise and create additional intrinsic value. All options have time value so long as time remains before expiration. The longer the time until expiration, other things being equal, the greater the time value. As a result all options will be undervalued by not recording their fair values. In fact, as discussed earlier, there usually is no “intrinsic value” (exercise price equals market price), resulting in no compensation being recorded at all.
  • 10. Chapter 18 Employee Benefit Plans 10 PERFORMANCE STOCK OPTION PLANS In the restricted stock award plans and stock option plans we discussed in the previous sections, both the number of shares employees can receive and the price they must pay to receive the shares (if any) are known when the awards are granted. For The terms of performance that reason, they often are referred to as “fixed plans.“ Sometimes, though, options vary with some measure of performance to tie compensation plans are structured in such a way that some of the terms needed to rewards to productivity. measure the compensation vary in response to some performance measure such as share price, sales, rate of return, or market share. These are known as “variable plans.” One example of a variable plan is a stock option plan in which the number of shares, the exercise price, or both vary with criteria related to managerial performance. For example, the criteria might be earnings per share, division revenues, rate of return on assets, or some other measure of performance. The number of shares obtainable under the option plan, for instance, might be calculated as some multiple of sales growth over the 2 years following the grant date. The possibilities are limitless. To achieve corporate objectives and maximize shareholder wealth, performance option plans are preferable to fixed plans because they directly tie management incentive to firm performance. Unfortunately, the vast majority of option plans have fixed terms. Why? The answer is simple. Unless a company opts for the FASB’s elective fair value approach, fixed plans allow the company to avoid reducing To avoid recording compensation, most options earnings with compensation expense (as discussed earlier). On the other hand, in a have fixed rather than variable variable plan, compensation expense usually is recorded whether the company terms. chooses the elective fair value approach or not. Here’s why: 1. By the FASB’s elective fair value approach, the fair value of the options is estimated at the grant date and accrued to expense over the service period. Even when terms vary with future performance, option-pricing models usually are capable of estimating the fair value. In cases when it is not possible to determine fair value, compensation is accrued each year based on the intrinsic value of the award, using option terms that would apply if the options were exercised that year. 2. By the alternate approach, the intrinsic value of the options is accrued to expense over the service period. But since the terms are dependent on performance, the measurement date is delayed until compensation can be measured but is estimated and recorded in the meantime. So, as long as performance measures indicate positive compensation under the terms of the options, expense is recorded. The way we estimate, record, and adjust compensation for revised estimates under the alternate approach is similar to the way we account for stock appreciation Accounting for performance rights (SARs), demonstrated in Illustration 18-6 in the next section, except the credit option plans under the alternate entry to recognize accrued compensation is Paid-in capital – stock options rather than approach is similar to accounting for SARs. Paid-in capital – SAR plan or Liability – SAR plan. Because performance option plans are found much less frequently in practice, we provide a detailed illustration for SARs. Just remember, the approach is the same for performance option plans. ADDITIONAL CONSIDERATION Companies that have performance plans or other variable plans may actually choose the elective fair value approach to reduce compensation expense. The amount of estimated compensation under a variable plan is adjusted for changes in the price of the underlying stock after the grant date. This can be avoided if the company opts to determine the total compensation as the fair value of the options on the grant date. The FASB does not permit a “mix-and-match” approach. If the fair value approach is chosen for performance plans, it must be used for all stock-based plans.
  • 11. Chapter 18 Employee Benefit Plans 11 Stock Appreciation Rights Stock appreciation rights (SARs) overcome a major disadvantage of stock option plans that require employees to actually buy shares when the options are exercised. Even though the options’ exercise price may be significantly lower than the market value of the shares, the employee still must come up with enough cash to take advantage of the “bargain.” This can be quite a burden if the award is sizable. In a nonqualified stock option plan, income taxes also would have to be paid when the options are exercised.10 SARs offer a solution. Like stock options, these awards enable an employee to benefit by the amount that the market price of the company’s stock rises without having to buy shares. Instead, the employee is awarded the “share appreciation,” In an SAR plan, the employer which is the amount by which the market price on the exercise date exceeds a pays compensation equal to the prespecified price (usually the market price at the date of grant). For instance, if the increase in share price from a specified level. share price rises from $35 to, say, $50, the employee receives $15 cash for each SAR held. The share appreciation usually is payable in cash or the recipient has the choice between cash and shares. A plan of this type offered by IBM is described in Graphic 18-11. Graphic 18-11 Stock Appreciation Rights – Long-term Performance Plan (in Part) IBM Corporation SARs offer eligible optionees the alternative of electing not to exercise the related stock option, but to receive payment in cash and/ or stock, equivalent to the difference between the option price and the average market price of IBM stock on the date of exercising the right. IS IT DEBT OR IS IT EQUITY? In some plans, the employer chooses whether to issue shares or cash at exercise. In If an employer can elect to settle in shares of stock rather than other plans, the choice belongs to the employee.11 Who has the choice determines the cash, the award is considered to way it’s accounted for. More specifically, the accounting treatment depends on be equity. whether the award is considered an equity instrument or a liability. If the employer can If an employee can elect to elect to settle in shares of stock rather than cash, the award is considered to be equity. receive cash, the award is On the other hand, if the employee will receive cash or can elect to receive cash, the considered to be a liability. award is considered to be a liability.12 The distinction between stock-based awards that are considered equity and those that are considered liabilities is based on the definition of liabilities in Concept Statement 6.13 That Statement classifies an instrument as a liability if it obligates the issuer to transfer its assets to the holder. A stock option is an equity instrument if it requires only the issuance of stock. A cash SAR, on the other hand, requires the The cash settlement of an equity transfer of assets, and therefore is a liability. This does not mean that a stock option award is considered the whose issuer may later choose to settle in cash is not an equity instrument. Instead, repurchase of an equity cash settlement would be considered equivalent to repurchasing an equity instrument instrument. for cash. 10The tax treatment of stock-based plans is discussed in an earlier section. 11Many such plans are called tandem plans and award an employee both a cash SAR and an SAR that calls for settlement in an equivalent amount of shares. The exercise of one cancels the other. 12The FASB’s elective accounting approach mandates the distinction between debt and equity to be whether the employee can choose cash or whether the employer can choose to settle in shares. A company not choosing to follow the elective approach decides which settlement method is most likely. The result usually is the same. 13Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford, Conn.: FASB 1985).
  • 12. Chapter 18 Employee Benefit Plans 12 SARS PAYABLE IN SHARES (EQUITY) When an SAR is considered to be equity (because the employer can elect to settle in shares of stock rather than cash), accounting depends on whether or not the company has chosen the elective fair value approach for stock-based compensation plans: 1. By the elective fair value approach, the fair value of the SARs is estimated at the grant date and accrued to expense over the service period. Normally, the fair value of an SAR is the same as the fair value of a stock option with the same terms. The fair value is determined at the grant date and accrued to compensation expense over the service period the same way as for other stock-based compensation plans. The total compensation is not revised for subsequent changes in the price of the underlying stock. 2. By the alternative intrinsic value approach, the intrinsic value of the SARs is accrued to expense over the service period. But since the terms are dependent on future stock price, the eventual compensation is estimated and recorded in the meantime. This is the same method used for performance stock options discussed earlier as well as for cash SARs discussed next. SARS PAYABLE IN CASH (LIABILITY) When an SAR is considered to be a liability (because the employee can elect to receive cash upon settlement), accounting does not depend on whether or not the company has chosen the elective fair value approach for stock-based compensation plans. Instead, consistent with recording other liabilities, the amount of compensation (and related liability) is estimated each period and continually adjusted to reflect changes in the market price of stock until the compensation is finally paid. A difficulty in accounting for cash SARs is that the amount of compensation (and eventual liability) are not known for certain until the compensation actually is paid – on the date the SAR is exercised. We solve this problem the usual way – by estimating the amounts needed for periodic reporting. The amount of total compensation is Total compensation expense estimated at the end of each period as the excess of the current market price of the reported to date is the estimated total compensation multiplied shares over the prespecified price (usually the market price at the date of grant). A by the fraction of the service portion of that total compensation is attributed to employee service during each period that has expired. reporting period and is recorded as compensation expense. The periodic expense (and adjustment to the liability) is the percentage of the total compensation earned to date by recipients of the SARs (based on the elapsed percentage of the service period) reduced by any amounts expensed in prior periods. For example, if the market price at the end of the period is $14 and was $10 at the grant date, the total compensation would be $40 million if 10 million SARs are expected to vest. Let’s say 2 years of a four-year service period have elapsed, and $5 million was expensed the first year. Then, compensation expense the second year would be $15 million, calculated as (2/4 of $40 million) minus $5. An example spanning several years is provided in Illustration 18-6.
  • 13. Chapter 18 Employee Benefit Plans 13 Illustration 18-6 Stock Appreciation Rights Universal Communications grants 10 million SARs to key executives at January 1, 2003. Upon exercise, the SARs entitle executives to receive cash or stock equal in value to the excess of the market price at exercise over the share price at the date of grant. The $1 par common shares have a current market price of $10 per share. The SARs vest at the end of 2006 (cannot be exercised until then) and expire at the end of 2010. The year-end share prices following the grant of the SARs are: 2003 – $12 2004 – $14 2005 – $16 2006 – $14 2007 – $15 January 1, 2003 No entry because the intrinsic value of the SARs is zero: [$10 – $10] x 10 million shares = $0 December 31, 2003 ($ in millions) When the share price rises Compensation expense* ............................................................................ 5 above $10, a liability is created. Liability – SAR plan............................................................................... 5 * Calculation: 1/ [$12-10] x 10 million x 4 – $0 = $5 estimated fraction expensed current total of service earlier expense compensation to date December 31, 2004 In 2004, both the expense and Compensation expense*............................................................................. 15 the liability are adjusted to Liability – SAR plan .............................................................................. 15 reflect, not only another year’s service, but also a revised * Calculation: estimate of total compensation. 2/ [$14-10] x 10 million x 4 – [$5 million] = $15 estimated fraction expensed current total of service earlier expense compensation to date December 31, 2005 Compensation expense* ............................................................................ 25 The 2005 expense is the revised Liability – SAR plan .............................................................................. 25 total compensation to be reported to date ($45 million) * Calculation: less the $20 million expensed 3/ previously. [$16-10] x 10 million x 4 – [$5 + 15 million] = $25 estimated fraction expensed current total of service earlier expense compensation to date December 31, 2006 Liability – SAR plan ................................................................................... 5 If the share price declines, both Compensation expense* ....................................................................... 5 the liability and expense are reduced. * Calculation: 4/ [$14-10] x 10 million x 4 – [$5 + 15 + $25 million] = $(5) estimated fraction expensed current total of service earlier expense compensation to date Note that the way we treat changes in compensation estimates entails a “catch-up” We make up for incorrect adjustment in the period of change, inconsistent with the usual treatment of a change previous estimates by adjusting expense in the period the in estimate. For most changes in estimate, including changes in forfeiture rates and estimate is revised. other estimates under the elective fair value approach described earlier, revisions are
  • 14. Chapter 18 Employee Benefit Plans 14 allocated (to compensation expense in this case) over remaining periods, rather than all at once in the period of change. The liability continues to be adjusted after the service period if the rights haven’t been exercised yet. Compensation expense and the December 31, 2007 ($ in millions) liability continue to be adjusted Compensation expense*........................................................................ 10 until the SARs expire or are Liability – SAR plan ....................................................................... 10 exercised. * Calculation: [$15-10] x 10 million x all – [$5 + 15 + $25 – $5million] = $10 estimated fraction expensed current total of service earlier expense compensation to date It’s necessary to continue to adjust both compensation expense and the liability Adjustment continues after the service period if the SARs have until the SARs ultimately either are exercised or lapse.14 Assume for example that the not yet been exercised. SARs are exercised on October 11, 2008, when the share price is $14.50, and executives choose to receive the market price appreciation in cash: Any credit to compensation October 11, 2008 ($ in millions) expense may not be more than Liability – SAR plan.......................................................................... 5 previous debits to that account. Compensation expense*.................................................................. 5 Liability – SAR plan (balance)......................................................... 45 Cash............................................................................................... 45 * Calculation: [$14.50-10] x 10 million x all – [$50 million] = $(5) actual fraction expensed current total of service earlier expense compensation to date Let’s look at the changes in the Liability – SAR plan account during the 2003-2008 period: Liability – SAR Plan Liability – SAR plan ($ in millions) __________________________________________________________ 5 2003 The liability is adjusted each 15 2004 period as changes in the share 25 2005 price cause changes in the 2006 5 liability estimates. 10 2007 2008 5 2008 45 ___ 0 balance after exercise The form of settlement As discussed earlier, if the employer had retained the choice of settling in shares determines whether rather than cash, the award would have been considered an equity instrument at the compensation expense is accrued as a liability or as paid- outset. In that case, unless the company uses the elective fair value approach, “Paid-in in capital. 14Except that the cumulative compensation expense cannot be negative; that is, the liability cannot be reduced below zero.
  • 15. Chapter 18 Employee Benefit Plans 15 capital – SAR plan” would replace the liability account in each of Universal’s journal entries above. Broad-Based (Noncompensatory) Plans Sometimes, long-term stock options are issued to substantially all employees rather than to certain targeted individuals. These so-called broad-based plans typically permit employees to buy shares within some specified number of years, say 10 years, at an exercise price equal to the stock’s price on the date the options are granted, or sometimes at a slight discount. Options of this type traditionally have been referred to as noncompensatory plans due to terminology used in the Tax Code. This term also is consistent with the reason most such plans exist. The plans encourage stock ownership among rank and file employees. As stakeholders, employees become more loyal and financially concerned with enhancing the value of common stock. As long as the price discount is no higher than (a) what would be reasonable in a recurring offer to shareholders or others or (b) the share issuance costs avoided by not having to finance a public offering of new stock, no entry is made when options are issued under a broad-based plan. These criteria are considered met if the discount is 5% or less.15 If and when those options are exercised, the company simply records the sale of new shares. Graphic 18-12 provides a summary of the effects of each type of stock-based compensation plan on compensation recorded and affected balance sheet categories. 15A discount of more than 5% without recording compensation expense is permitted by SFAS 123 if the company can justify it under criteria (a) and (b) above.
  • 16. Chapter 18 Employee Benefit Plans 16 Graphic 18-12 Elective Alternative Income Statement and Fair Value Approach Intrinsic Value Approach Balance Sheet Impact of TOTAL TOTAL Stock-Based Compensation TYPE OF PLAN COMPENSATION BALANCE SHEET COMPENSATION BALANCE SHEET Plans Fair value Restricted Shareholders’ same as fair same as fair value Amount fixed at (nonvested) equity: value approach approach grant date, stock award Paid-in capital – accrued to restricted stock service period Intrinsic value Fair value Fixed stock Shareholders’ Amount fixed at Shareholders’ Amount fixed at options equity: grant date, equity: grant date, Paid-in capital – accrued to Paid-in capital – accrued to stock options service period stock options service period Intrinsic value Fair value Shareholders’ Amount varies Shareholders’ Amount fixed at Performance equity: until option equity: grant date, (variable) stock Paid-in capital – terms are Paid-in capital – accrued to options stock options known, stock options service period estimates expensed until then Share price Fair value appreciation Stock appreciation Shareholders’ Shareholders’ Amount fixed at rights equity: Amount varies equity: grant date, (share payment Paid-in capital - until exercise Paid-in capital - accrued to choice of SAR plan (or lapse), SAR plan service period employee) estimates expensed until then Stock Share price appreciation appreciation Liabilities: same as fair same as fair value rights Liability - SAR value approach approach Amount varies (cash payment plan until exercise choice of (or lapse), employer) estimates expensed until then Broad-based Shareholders’ same as fair same as fair value plans (non- none equity: value approach approach compensatory) only when shares are sold

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