Employee Stock Options

1

FAS 123 (R) (fair value model)

Note that use of APB 25 is no longer permitted

Employee Stock Options

2

A. NON-COMPENSATORY PLANS

Conditions:

• All Employees

• Equal opportunity for all eligible employees

• Limited time offer

• Limited discount (same as offered to existing stockholders

Accounting Issues: None, no compensation expense

3

B. Compensatory Plans

1. Incentive Plans

• No tax to employee when exercised, only when stock is sold

• Tax law requires that option price on grant date is equal to the market price

• Compensation expense = fair value of options

4

2. Non-qualified Plans

• Employees taxed when option exercised

• Taxed on the difference between market price and exercise price

• Company receives tax deduction

• Option price may be lower than market price on the measurement date

• Compensation expense must be recognized

5

Terms

Option - opportunity to buy stock at fixed price (Exercise price)

Grant date - date on which employee receives option

Measurement date - date on which both the number of shares and the exercise price are known

6

Terms

Compensation expense – fair market value of options – determined through use of option pricing model

Service Period - time period over which compensation expense is amortized

7

Example - Data

# of Options issued 10,000Service Period 3 yearsExercise Price of stock $20Market Price of option $6Expected forfeiture 10%

8

Dr. deferred compensation expense $54,000

cr. Paid in capital - options $54,000

(10,000 * 6 *.9) – adjusted for expected forfeitures

dr. compensation expense $18,000

cr. Deferred compensation expense $18,000

(record issuance of options and first year compensation expense) Note that deferred compensation expense will offset PIC options)

9

Exercise of 80% of options

Dr. cash $160,000

dr. paid in capital - options $ 48,000

cr. Common stock ($1 par) $ 8, 000

cr. Additional paid in capital $200,000

dr. compensation expense $ 12,000

Dr. Paid in capital – options $ 6,000

cr. Deferred compensation expense $18,000

(adjusted for additional forfeited options)

10

Stock Appreciation Plans

Non qualified plansEmployee receives cash based on

the increase in stock valueUsed to generate cash, i.e., for tax

when options are exercisedCompensation expense must be

estimated between grant and exercise date

11

Total est. Cumulative Expense Deferredcompensation compensation debit expense

expense expense (credit) balance# of options 10000Option price $15Market 1 $20 $50,000 $12,500 $12,500 37500Market 2 $22 $70,000 $35,000 $22,500 35000Market 3 $18 $30,000 $22,500 ($12,500) 7500Market 4 $24 $90,000 $90,000 $60,000 0

12

Year 1dr. compensation expense $12,500dr. deferred compensation expense $37,500cr. Liability - stock appreciation plan $50,000

Year 2dr. compensation expense $22,500 cr. Deferred compensation expense $2,500 cr. Liability - stock appreciation plan $20,000

13

Year 3dr. liability - stock appreciation plan $40,000 cr. Compensation expense $12,500 cr. Deferred compensation expense $27,500

Year 4dr. compensation expense $60,000 cr. Deferred compensation expense $7,500 cr. Liability - stock appreciation plan $60,000

14

FAS 123 versus APB 25

Compensation expense based on market value of option

Black-Sholes Option pricing model used

Compensation expense is always recognized

Compensation expense only if market > exercise price on grant date

For most plans No compensation expense is recognized

15

Required Disclosures under FAS 123

# of shares under option plan# of options issued, exercised, lapsedweighted av. option price per categoryweighted av. fair value of options granted assumptions made to estimate fair valueAverage remaining contractual life of

options outstanding