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Chapter 19:Share-Based Compensation

ASC 718 (SFAS 123R)

Learning Objectives

1. Accounting for stock award plans.

2. Accounting for stock options.

3. Accounting for employee share purchase plans.

4. Simple and a complex capital structure.

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Share-Based CompensationForm of compensation in which the amount of the compensation employees receive is tied to the market price of company stock.

An executive compensation plan is tied to performance in a strategy that uses compensation to motivate it recipients.

These share-based compensation plans –stock awards, -stock options, and -stock appreciation rights,create shareholders’ equity.

The nature of this compensation will impact the way earnings per share is calculated.

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Share-Based Compensation

Whichever form such a plan assumes, the accounting objective is to record the fair value of compensation expense over the periods in which related services are performed.

This requires:

1. Determining the fair value of the compensation.

2. Expensing that compensation over the periods in which participants perform services.

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Stock Award Plans

FEATURES:

The compensation is a grant of shares of stock.

-The shares usually are restricted (non-vested) so that benefits are tied to continued employment.

-Usually shares are subject to forfeiture if employment is terminated within some specified number of years from the date of grant.

-The employee cannot sell the shares during the restriction period. => Between GRANT Date and VESTING Date.

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Stock Award Plans

Compensation is a grant of shares of stock….

-The compensation is simply the market price of the stock at the grant date.

-Compensation is accrued as expense over the service period for which participants receive the shares.

-The service period usually is the period from the date of grant to when restrictions are lifted (the vesting date).

-If restricted stock is forfeited, related entries previously made would simply be reversed.

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STOCK AWARD PLANS ILLUSTRATION

Under its restricted stock award plan, Universal Communications grants 5 million of its $1 par common shares to certain key executives at January 1, 2011. The shares are subject to forfeiture if employment is terminated within 4 years. Shares have a current price of $12 per share.

January 1, 2011No entry

Calculate total compensation expense: $12 Fair value per share

x 5 million Shares awarded= $60 million Total compensation

The total compensation is allocated to expense over the 4-year service (vesting) period: 2011 – 2014 as follows:

$60 million ÷ 4 years = $15 million per year

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STOCK AWARD PLANS ILLUSTRATION

Journal Entries:

December 31, 2011, 2012, 2013, 2014 ($ in millions):Compensation expense ($60 million ÷ 4 years) 15

Paid-in capital – restricted stock 15 December 31, 2014 (On Vesting Date): Paid-in capital– restricted stock (5 million sh. at $12) 60

Common stock (5 million shares at $1 par) 5Paid-in capital – excess of par (to balance) 55

If restricted stock is forfeited because, say, the employee quits the company, related entries previously made would simply be reversed.

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STOCK AWARD PLANS

Exercise 19-1Exercise 19-2Exercise 19-4

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Stock Option Plans

Stock option plansStock option plans give employees the give employees the option to buy option to buy

(a)(a) a specified a specified numbernumber of shares of the firm's stock, of shares of the firm's stock,

(b)(b) at a specified at a specified exercise priceexercise price,,

(c)(c) during a specified during a specified period of timeperiod of time. .

The The fair valuefair value is accrued as is accrued as compensation expense compensation expense over the service periodover the service period for which participants receive for which participants receive the options, usually from the the options, usually from the date of grant date of grant to when to when the options become exercisable (the options become exercisable (the vesting datethe vesting date). ).

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Expense – The Great Debate

Historically, options have been measured at their intrinsic value – the simple difference between the market price of the shares and the option price at which they can be acquired.

If the market and exercise price are equal on the date of grant, no compensation expense is recognized even if the options provide executives with substantial income.

Historically, options have been measured at their intrinsic value – the simple difference between the market price of the shares and the option price at which they can be acquired.

If the market and exercise price are equal on the date of grant, no compensation expense is recognized even if the options provide executives with substantial income.

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Failed Attempt to Require ExpensingOpposition to a proposed FASB Statement to Opposition to a proposed FASB Statement to recognize expense for certain stock option recognize expense for certain stock option plans have identified three objections.plans have identified three objections.

1.1. Options with Options with no intrinsic value no intrinsic value at issue at issue have zero fair value and should have zero fair value and should notnot give give rise to expense recognition.rise to expense recognition.

2.2. It is It is impossible impossible to measure the fair value to measure the fair value

of compensationof compensation on the date of grant. on the date of grant.

3.3. Current practices have unacceptable Current practices have unacceptable economic consequences.economic consequences.

Opposition to a proposed FASB Statement to Opposition to a proposed FASB Statement to recognize expense for certain stock option recognize expense for certain stock option plans have identified three objections.plans have identified three objections.

1.1. Options with Options with no intrinsic value no intrinsic value at issue at issue have zero fair value and should have zero fair value and should notnot give give rise to expense recognition.rise to expense recognition.

2.2. It is It is impossible impossible to measure the fair value to measure the fair value

of compensationof compensation on the date of grant. on the date of grant.

3.3. Current practices have unacceptable Current practices have unacceptable economic consequences.economic consequences.

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Recognizing Fair Value of Options

Accounting for stock options parallels the accountingAccounting for stock options parallels the accountingfor restricted stock we discussed earlier. for restricted stock we discussed earlier. We now are rWe now are required to estimate the fair value of equired to estimate the fair value of stock option stock option on the on the grant date.grant date.

Accounting for stock options parallels the accountingAccounting for stock options parallels the accountingfor restricted stock we discussed earlier. for restricted stock we discussed earlier. We now are rWe now are required to estimate the fair value of equired to estimate the fair value of stock option stock option on the on the grant date.grant date.

The FASB now requires that compensation expense The FASB now requires that compensation expense be measured using one of several be measured using one of several option pricing option pricing models models that deal with:that deal with:

1.1. Exercise price of the option.Exercise price of the option.2. Expected term of the option.2. Expected term of the option.3. Current market price of the stock.3. Current market price of the stock.4. Expected dividends.4. Expected dividends.5. Expected risk-free rate of return.5. Expected risk-free rate of return.6. Expected volatility of the stock.6. Expected volatility of the stock.

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EXPENSING STOCK OPTIONSAt January 1, 2011, Universal Communications grants

options that permit key executives to acquire 10 million of the company’s $1 par common shares within the next 8 years, but not before December 31, 2014 (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, 2011No entry

Calculate total compensation expense: $8 estimated fair value per option

x 10 million options granted= $80 million total compensation

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EXPENSING STOCK OPTIONS

At January 1, 2011, Universal Communications grants options that permit key executives to acquire 10 million of the company’s $1 par common shares within the next 8 years, but not before December 31, 2014 (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.

The total compensation is allocated to expense over the 4-year service (vesting) period: 2011 - 2014

$80 million ÷ 4 years = $20 million per year

December 31, 2011, 2012, 2013, 2014($ in millions)Compensation expense ($80 million ÷ 4 years) 20

Paid-in capital – stock options 20

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EXPENSING STOCK OPTIONS

ESTIMATED FORFEITURES  If a forfeiture rate of 5% was expected, annual compensation expense would have been $19 million ($76 / 4) instead of $20

million.

During 2013, the third year, Universal revises its estimate of forfeitures from 5% to 10%. The new estimate of total compensation would then be $80 million x 90%, or $72 million. The expense each year is the current estimate of total compensation that should have been recorded to date less the amount already recorded.

3rd Year = $16M = ($80 million x 90% x ¾) – [$19 + 19]) 4th Year = $18M = ([$80 million x 90% x 4/4] – [$19 + 19 + 16])

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EXPENSING STOCK OPTIONS

ESTIMATED FORFEITURES 2011 ($ in millions)Compensation expense ($80 x 95% x 1/4) 19

Paid-in capital –stock options 192012Compensation expense ($80 x 95% x 1/4) 19

Paid-in capital –stock options 192013Compensation expense ([$80 x 90% x ¾] – [$19 + 19]) 16

Paid-in capital –stock options 162014Compensation expense ([$80 x 90% x 4/4] – [$19 + 19 + 16]) 18

Paid-in capital –stock options 18

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EXPENSING STOCK OPTIONSWHEN OPTIONS ARE EXERCISEDIf half the options (five million shares) are exercised on July 11, 2014, when the market price is $50 per share, the following journal entry is made: July 11, 2014 ($ in millions)Cash ($35 exercise price x 5 million shares) 175Paid-in capital - stock options (1/2 account balance) 40

Common stock (5 million shares at $1 par per share) 5Paid-in capital – excess of par (to balance) 210

 

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STOCK OPTIONS

Exercise 19-5Exercise 19-6Exercise 19-8

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EXPENSING STOCK OPTIONS

WHEN VESTED OPTIONS EXPIRE WITHOUT BEING EXERCISEDIf options that have vested expire without being exercised, the following journal entry is made (assuming none of the options were exercised):  ($ in millions)Paid-in capital – stock options (account balance) 80

Paid-in capital – expiration of stock options 80

Exercise 19-7(#5)BE 19-2 & 5

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EXPENSING STOCK OPTIONSPLANS WITH PERFORMANCE OR MARKET CONDITIONSThe way we account for such plans depends on whether the condition is performance-based or market-based.

Performance Target Example:An option may not be exercisable until a performance target is met.The target could be: -Divisional revenue, -Earnings per share, -Sales growth or -ROA.

Market-related Targets:-A specified stock price; -A stock price change exceeding a particular index;

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EXPENSING STOCK OPTIONSPlans with Performance Conditions If compensation from a stock option depends on meeting a performance target, then whether we record compensation depends on whether or not we feel it’s probable the target will be met.

If the initial expectation is that it is not probable that the target will be met, we record no annual compensation expense. 2011:NO ENTRY

2012:NO ENTRY

If, after two years, the expectation is that it is probable that the target will be met, we record the cumulative effect on compensation in 2013 earnings and record compensation thereafter:

2013Compensation expense ([$80 x ¾] - $0) 60

Paid-in capital –stock options 602014Compensation expense ([$80 x 4/4] - $60) 20

Paid-in capital –stock options 20

BE 19-6,

BE 19-7, BE 19-8

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EXPENSING STOCK OPTIONSPlans with Market Conditions If the award contains a market condition (e.g., a stock option with an exercisability requirement based on the stock price reaching a specified level), then we recognize compensation expense regardless of when, if ever, the market condition is met.

Meaning, no special accounting is required!!

REASON:The fair value estimate of the stock options based on Option Pricing Models already incorporated market conditions.

BE 19-9

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Plans With Graded-VestingRather than stock option plans vesting on a single date, more plans awards specify that recipients gradually become eligible to exercise their options rather than all at once. This is called “graded vesting.” Accounting for compensation expense may be handled:

1The company may estimate a single fair value for each of the options, even though they vest

over different time periods, using a single weighted-

average expected life of the options.

2The company may use a slightly more

complex method because it usually results in lower expense. In this approach, we view each vesting group separately, as if it

were a separate award.

For example, a company may award stock options that vest 25% in the first year, 25% in second year, and 50% the

third years.

For accounting purposes we have three separate awards.

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Plans With Graded-Vesting

Illustration 19-3 (Page 1078)

Graded vesting

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U.S. GAAP vs. IFRS

• Account for each vesting amount separately or account for the entire award on the straight-line basis over the entire vesting period.

There are more similarities than differences in the treatment of stock options. One major difference is the treatment of deferred tax assets and when options have graded-vesting.

• Straight-line choice is not permitted. Companies not required to recognize the award that has vested by each reporting date.

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Employee Share Purchase Plans Permit employees to buy shares directly from

their employer. Usually the plan is considered compensatory,

and compensation expense is recorded. Employees may buy 100 shares of no par stock

for $8.50 per share. The current market price is $10.00. The $1.50 discount is recorded as compensation expense:

Cash (100 × $8.50) 850Compensation expense (100 × $1.50) 150

Common stock (100 × $10.00) 1,000

Market valueMarket value

Exercise 19-9

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Tax Implications For tax purposes, plans can either qualify as an “incentive stock option plan” (qualified) under the Tax Code or be "unqualified plans." Among the requirements of a qualified option plan is that the exercise price be equal to the market price at the grant date. Under a qualified incentive plan:

-The recipient pays no income tax until any shares acquired are subsequently sold.

-On the other hand, the company gets no tax deduction at all.

With a non-qualified plan: -the employee can’t delay paying income tax, and

-the employer is permitted to deduct the difference between the exercise price and the market price at the exercise date.

Example: Page 190: Additional Consideration: Tax Consequences….

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U.S. GAAP vs. IFRS

• A deferred tax asset (DTA) is created for the cumulative amount of the fair value of the options the company has recorded for compensation expense.

There are more similarities than differences in the treatment of stock options. One major difference is the treatment of deferred tax assets and when options have graded-vesting.

• The deferred tax asset is not created until the award is “in the money;” that is it has intrinsic value.

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Home Work

Problem 19-1Problem 19-2Problem 19-3

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Part B: Earnings Per Share I. For analysts and the financial press, earnings per share is the most frequently cited and reported measure of a company’s performance.

A. EPS is reported in the income statement of all publicly traded firms.

B. In general, EPS is simply earnings available to common shareholders divided by the weighted average number of common shares outstanding.

II. If a company has no “potential common shares” we consider it to have a simple capital structure.

A. For a simple capital structure, a single presentation of basic EPS is sufficient.

B. If there are no securities other than common stock and the number of common shares remained unchanged, basic EPS is simply net income divided by common shares.

EARNINGS AVAILABLE TO COMMON SHAREHOLDERSPreferred dividends are subtracted from net income so that “earnings available to common shareholders” is divided by the weighted average number of common shares.

EXAMPLE:Sovran Financial Corporation reported net income of $154 million in 2011 (tax rate 40%).

Its capital structure included:

Common stockJanuary 1 60 million common shares were outstanding March 1 12 million new shares were soldJune 17 A 10% stock dividend was distributed October 1 8 million shares were reacquired as treasury stock

Preferred stock, nonconvertibleJanuary 1 5 million 8%, $10 par, shares outstanding

EARNINGS AVAILABLE TO COMMON SHAREHOLDERS

Basic EPS:(amounts in millions, except per share amount)

net preferred

income dividends

$154 – $4 * = $150 = $2

60(1.10) + 12 (10/12)(1.10) – 8 (3/12) = 75 Shares new treasury at Jan. 1 shares shares _____stock dividend_______ adjustment

•5,000,000 x $10 x 8% = $4

EXERCISE 19-14

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Diluted Earnings Per Share

When a company has securities that could potentiallyDilute (i.e., reduce) earnings per share, it is classified as acomplex capital structure.

These potential common shares include stock options And Convertible securities.

The company reports both basic and diluted earnings pershare.

For diluted EPS, the impact of each potentially dilutivesecurity is reflected by calculating earnings per share as if the security already had been exercised or convertedinto additional common shares.

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Complex Capital StructureComplex Capital Structure(dual EPS)(dual EPS)

Dilution/Antidilution TestDilution/Antidilution Test

StockStockOptionsOptions

Convertible Convertible securitiessecurities

Treasury Treasury stock methodstock method

If-converted If-converted methodmethod

Contingently Contingently issuable issuable sharesshares

Potential Common Shares:Potential Common Shares:•Stock options, rights, and Stock options, rights, and warrants warrants•Convertible bonds and stockConvertible bonds and stock•Contingent common stock Contingent common stock issues issues

Potential Common Shares:Potential Common Shares:•Stock options, rights, and Stock options, rights, and warrants warrants•Convertible bonds and stockConvertible bonds and stock•Contingent common stock Contingent common stock issues issues

Diluted Earnings Per Share

May Report Basic EPS and Diluted EPS

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Options, Rights, and Warrants

ProceedsProceeds

Used toUsed to

Purchase Purchase treasury treasury sharesshares

At At average average market market priceprice

The The treasury stock methodtreasury stock method assumes that assumes that proceeds proceeds from the exercise of from the exercise of optionsoptions are are used to used to purchase treasury sharespurchase treasury shares. .

This method usually This method usually resultsresults in a in a net increase in shares net increase in shares included in the included in the denominator of the denominator of the calculation of calculation of diluted diluted earnings per share.earnings per share.

The The treasury stock methodtreasury stock method assumes that assumes that proceeds proceeds from the exercise of from the exercise of optionsoptions are are used to used to purchase treasury sharespurchase treasury shares. .

This method usually This method usually resultsresults in a in a net increase in shares net increase in shares included in the included in the denominator of the denominator of the calculation of calculation of diluted diluted earnings per share.earnings per share.

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Options, Rights, and Warrants1.1. Determine new shares from Determine new shares from assumed exercise assumed exercise of stock optionsof stock options

2. Compute shares purchased from the treasury. 2. Compute shares purchased from the treasury.

3. Compute the incremental shares assumed outstanding:3. Compute the incremental shares assumed outstanding:

New shares from assumed exercise (1)

Less: Treasury shares assumed purchased (2)

= Net increase in shares outstanding (3)

Proceeds from assumed exerciseProceeds from assumed exercise

Average-of-period market price of stockAverage-of-period market price of stock

Proceeds from assumed exerciseProceeds from assumed exercise

Average-of-period market price of stockAverage-of-period market price of stock

Illustration 19-9 (Page 202): Stock OptionsExercise 19-15 & 19-16

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Options, Rights, and Warrants

When the When the exercise price exercise price exceeds the market priceexceeds the market price, , the securities are the securities are antidilutive antidilutive and and are excluded are excluded from the from the calculation of diluted EPS.calculation of diluted EPS.

When the When the exercise price exercise price exceeds the market priceexceeds the market price, , the securities are the securities are antidilutive antidilutive and and are excluded are excluded from the from the calculation of diluted EPS.calculation of diluted EPS.

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Convertible Securities

The The if-converted methodif-converted method is used for is used for Convertible debt and equity Convertible debt and equity

securities.securities.The method assumes conversion occurs The method assumes conversion occurs

as of the as of the beginningbeginning of the period or date of the period or date ofof issuance issuance, if later., if later.

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Restricted Stock Awards

Restricted stock awards are quickly replacing Restricted stock awards are quickly replacing stock options as the share-based compensation stock options as the share-based compensation plan of choice. Like stock options, the treasury plan of choice. Like stock options, the treasury stock method is used to calculate the number of stock method is used to calculate the number of shares in the denominator of the EPS equation. shares in the denominator of the EPS equation. Unlike stock option, employees do not pay to Unlike stock option, employees do not pay to acquire their shares of stock.acquire their shares of stock.

No adjustment to the numeratorDenominator is increased using treasury method

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Summary

Potential Common Shares Basic EPS Diluted EPS Stock options (or warrants, rights) no yes Restricted stock awards no yes Convertible securities (bonds, notes, preferred stock) no yes Contingently issuable shares no yes

Dilutive Effect Shown?

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Summary

Potential Common Shares Numerator Denominator

Stock options (or warrants, rights) None Add incremental

shares

Restricted stock award None

Add shares created by vesting, reduced

by repurchased shares at the

average stock price

Convertible bonds or notes Add after tax

interest

Add shares issuable upon

conversion

Convertible preferred Add back dividends

declared

Add shares issuable upon

conversion Contingently issuable shares

Conditions being currently met None Add shares

issuable Conditions not being met None None

Modification to EPS Equation

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Financial Statement Presentation

Report EPS data separately for:

1. Income from Continuing Operations

2. Separately Reported Items

a) Discontinued Operations

b) Extraordinary Items

3. Net Income

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Appendix 19A – Option-Pricing Theory

Intrinsic value Intrinsic value is the benefit the holder of an is the benefit the holder of an option would realize by exercising the option option would realize by exercising the option

rather than buying the underlying stock directly. rather than buying the underlying stock directly. An option that permits an employee to buy $25 An option that permits an employee to buy $25

stock for $10, has an intrinsic value of $15.stock for $10, has an intrinsic value of $15.

Intrinsic value Intrinsic value is the benefit the holder of an is the benefit the holder of an option would realize by exercising the option option would realize by exercising the option

rather than buying the underlying stock directly. rather than buying the underlying stock directly. An option that permits an employee to buy $25 An option that permits an employee to buy $25

stock for $10, has an intrinsic value of $15.stock for $10, has an intrinsic value of $15.

Options have a time Options have a time value because the value because the

holder of an option does holder of an option does not have to pay the not have to pay the

exercise price until the exercise price until the option is exercised.option is exercised.

Options have a time Options have a time value because the value because the

holder of an option does holder of an option does not have to pay the not have to pay the

exercise price until the exercise price until the option is exercised.option is exercised.

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SummaryThe fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component.

The fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component.

All Other Factors Being Equal, If the: The Option Value Will Be: Exercise price is higher Lower Term of the option is longer Higher Market price of the stock is higher Higher Dividends are higher Lower Risk-free rate of return is higher Higher Volatility of the stock is higher Higher

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Appendix 19B - Stock Appreciation Rights

• A. SARs enable an executive to benefit by the amount that the market price of the company’s stock rises, but without having to buy shares.

• B. The executive receives the “share appreciation” at exercise that has occurred since the date of grant.

• C. Share appreciation is the increase in the market price over a pre-specified price (usually the market price at the date of grant).

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Appendix 19B - Stock Appreciation Rights

The SARs are considered to be equity if the employer can elect to settle in shares of stock.

The amount of compensation is estimated at the grant date as the fair value of the SARs.

This amount is expensed over the service period.

Usually the same as the fair Usually the same as the fair value of a stock option with value of a stock option with

similar terms.similar terms.

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Stock Appreciation Rights The SARs are considered to be a liability if the

employee can elect to receive cash upon settlement. In that case, the amount of compensation (and related liability) is estimated each period and continuously adjusted to reflect changes in the fair value of the SARs until the compensation is finally paid.

The current expense (and adjustment to the liability) is the fraction 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.

End of Chapter 19