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Stock-Based Compensation

Stock-Based Compensation. Employee compensation made in the form of stock awards or tied to changes in market value of the company’s stock Stock-based compensation plans Noncompensatory – employee stock purchase plans No special accounting treatment Compensatory. Compensatory Plans.

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Stock-Based Compensation

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  1. Stock-Based Compensation • Employee compensation made in the form of stock awards or tied to changes in market value of the company’s stock • Stock-based compensation plans • Noncompensatory – employee stock purchase plans • No special accounting treatment • Compensatory

  2. Compensatory Plans • Stock appreciation rights plans • Performance-type plans • Stock option plans • Incentive plans • Nonqualified plans

  3. Stock Appreciation Rights • Executives are paid bonus in stock or cash based on increase in market price of stock • Total compensation is measured when rights are exercised; estimated in interim reporting periods

  4. Performance-Type Plans • Number of shares of stock awarded to executive is tied to performance criteria, e.g. earnings growth • Total Compensation is the market value of shares issued (measured when stock is awarded); estimated in interim reporting periods

  5. Stock Option Plans • Executives are granted options to purchase company stock at a pre-established price • Options are “earned” during service period between date of grant and initial exercise date • Value of options depends on increases in market price of stock • Accounting issue has been whether and how to measure “cost” to company of granting stock options

  6. Measuring the Value of Stock Options • Intrinsic value = excess of market price of stock over exercise price • Time value = speculative value of option based on characteristics of stock and duration of the option • Fair value = intrinsic value + time value • Determined in market if option is traded • May be estimated using an option pricing model

  7. Stock Option Plans – Incentive vs. Nonqualified Plans • Distinction is based on tax law • Incentive plan provides greater tax benefits to executives • To qualify as incentive stock option, the exercise price cannot be less than market price at date of grant; that is • Incentive stock options have an intrinsic value of zero when granted

  8. Accounting for Stock Option Plans - Chronology • APBO No. 25 - Intrinsic Value (IV) method • Superseded by SFAS 123 (revised 2004) • SFAS No. 123 - Original – “Stock-Based Compensation” • Allowed two methods of accounting • Intrinsic value method • Fair value method • Additional disclosures required if IV method used • SFAS 123 “encouraged” use of Fair Value method • SFAS No. 123 (revised 2004) – “Share-Based Payment” • Requires use of fair value method (with some modifications from SFAS No. 123 (original))

  9. Intrinsic Value MethodAPBO 25 • Total compensation cost is measured as the intrinsic value of the option at the date granted • measured once at the date the options are granted • Total compensation cost is allocated (recognized) over the service period on a straight-line basis • PROBLEM! Total compensation cost for incentive stock options will be ZERO

  10. Fair Value MethodSFAS No. 123 (Original) • Total compensation cost is measured using an option pricing model to estimate fair value of options • Total compensation cost is measured once at the date the options are granted • Total compensation cost is allocated (recognized) over the service period on a straight-line basis • Option pricing models • Mathematical models developed by finance researchers • Models estimate market value of an option based on factors including Duration of option and Volatility of stock

  11. Fair Value MethodSFAS No. 123 (revised 2004) • Issued in December 2004 • Eliminates intrinsic value method as acceptable method of accounting for compensatory stock options; Requires the fair value method • Option pricing model may be adjusted for “unique characteristics of those instruments” • Compensation is recognized over the period in which the employee is required to provide services (expected forfeitures are estimated when the options are granted)

  12. SFAS No. 123 Disclosures • Description of option plan(s) • Number of options and weighted-average exercise price • Description of method (option pricing model) and significant assumptions used to estimate fair value of options

  13. What Next? • The FASB (with the support of the SEC) has now required companies to expense the fair value of equity instruments granted to employees • Many companies (and others) still oppose the FASB’s position • Legislation??

  14. Additional information? The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America By Alex Berenson Chapter 7 - Options

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