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19 - 1 Chapter 19: Share-Based Compensation ASC 718 (SFAS 123R) Learning Objectives 1. Accounting for stock award plans. 2. Accounting for stock options.

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Presentation on theme: "19 - 1 Chapter 19: Share-Based Compensation ASC 718 (SFAS 123R) Learning Objectives 1. Accounting for stock award plans. 2. Accounting for stock options."— Presentation transcript:

1 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.

2 Share-Based Compensation Form 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.

3 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.

4 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.

5 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.

6 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, The shares are subject to forfeiture if employment is terminated within 4 years. Shares have a current price of $12 per share. January 1, 2011 No entry Calculate total compensation expense: $12Fair value per share x 5 millionShares awarded = $60 millionTotal 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

7 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 stock15 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) 5 Paid-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.

8 STOCK AWARD PLANS Exercise 19-1 Exercise 19-2 Exercise 19-4

9 Stock Option Plans Stock option plans give employees the option to buy (a) a specified number of shares of the firm's stock, (b) at a specified exercise price, (c) during a specified period of time. (c) during a specified period of time.  The fair value is accrued as compensation expense over the service period for which participants receive the options, usually from the date of grant to when the options become exercisable (the vesting date).

10 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.

11 Failed Attempt to Require Expensing Opposition to a proposed FASB Statement to recognize expense for certain stock option plans have identified three objections. 1.Options with no intrinsic value at issue have zero fair value and should not give rise to expense recognition. 2.It is impossible to measure the fair value of compensation on the date of grant. 3.Current practices have unacceptable economic consequences. Opposition to a proposed FASB Statement to recognize expense for certain stock option plans have identified three objections. 1.Options with no intrinsic value at issue have zero fair value and should not give rise to expense recognition. 2.It is impossible to measure the fair value of compensation on the date of grant. 3.Current practices have unacceptable economic consequences.

12 Recognizing Fair Value of Options Accounting for stock options parallels the accounting for restricted stock we discussed earlier. We now are required to estimate the fair value of stock option on the grant date. Accounting for stock options parallels the accounting for restricted stock we discussed earlier. We now are required to estimate the fair value of stock option on the grant date. The FASB now requires that compensation expense be measured using one of several option pricing models that deal with: 1. Exercise price of the option. 2. Expected term of the option. 3. Current market price of the stock. 4. Expected dividends. 5. Expected risk-free rate of return. 6. Expected volatility of the stock.

13 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. January 1, 2011 No entry Calculate total compensation expense: $8estimated fair value per option x 10 millionoptions granted = $80 milliontotal compensation

14 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: $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 options20

15 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. 3 rd Year = $16M = ($80 million x 90% x ¾) – [$ ]) 4 th Year = $18M = ([$80 million x 90% x 4 / 4 ] – [$ ])

16 EXPENSING STOCK OPTIONS ESTIMATED FORFEITURES 2011($ in millions) Compensation expense ($80 x 95% x 1 / 4 )19 Paid-in capital –stock options Compensation expense ($80 x 95% x 1 / 4 )19 Paid-in capital –stock options Compensation expense ([$80 x 90% x ¾] – [$ ])16 Paid-in capital –stock options Compensation expense ([$80 x 90% x 4 / 4 ] – [$ ])18 Paid-in capital –stock options 18

17 EXPENSING STOCK OPTIONS WHEN OPTIONS ARE EXERCISED If 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 )175 Paid-in capital - stock options (1/2 account balance) 40 Common stock (5 million shares at $1 par per share ) 5 Paid-in capital – excess of par (to balance) 210

18 STOCK OPTIONS Exercise 19-5 Exercise 19-6 Exercise 19-8

19 EXPENSING STOCK OPTIONS WHEN VESTED OPTIONS EXPIRE WITHOUT BEING EXERCISED If 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 options80 Exercise 19-7(#5) BE 19-2 & 5

20 EXPENSING STOCK OPTIONS PLANS WITH PERFORMANCE OR MARKET CONDITIONS The 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;

21 EXPENSING STOCK OPTIONS Plans 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: 2013 Compensation expense ([$80 x ¾] - $0)60 Paid-in capital –stock options Compensation expense ([$80 x 4/4] - $60)20 Paid-in capital –stock options 20 BE 19-6, BE 19-7, BE 19-8

22 EXPENSING STOCK OPTIONS Plans 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

23 Plans With Graded-Vesting Rather 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: 1 The 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. 2 The 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.

24 Plans With Graded-Vesting Illustration 19-3 (Page 1078) Graded vesting

25 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.

26 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 $ The $1.50 discount is recorded as compensation expense: Cash (100 × $8.50)850 Compensation expense (100 × $1.50)150 Common stock (100 × $10.00) 1,000 Market value Exercise 19-9

27 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….

28 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.

29 Home Work Problem 19-1 Problem 19-2 Problem 19-3

30 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.

31 EARNINGS AVAILABLE TO COMMON SHAREHOLDERS Preferred 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 stock January 160 million common shares were outstanding March 112 million new shares were sold June 17A 10% stock dividend was distributed October 18 million shares were reacquired as treasury stock Preferred stock, nonconvertible January 15 million 8%, $10 par, shares outstanding

32 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

33 Diluted Earnings Per Share When a company has securities that could potentially Dilute (i.e., reduce) earnings per share, it is classified as a complex capital structure. These potential common shares include stock options And Convertible securities. The company reports both basic and diluted earnings per share. For diluted EPS, the impact of each potentially dilutive security is reflected by calculating earnings per share as if the security already had been exercised or converted into additional common shares.

34 Complex Capital Structure (dual EPS) Dilution/Antidilution Test Stock Options Convertible securities Treasury stock method If-converted method Contingently issuable shares Potential Common Shares: Stock options, rights, and warrantsStock options, rights, and warrants Convertible bonds and stockConvertible bonds and stock Contingent common stock issuesContingent common stock issues Potential Common Shares: Stock options, rights, and warrantsStock options, rights, and warrants Convertible bonds and stockConvertible bonds and stock Contingent common stock issuesContingent common stock issues Diluted Earnings Per Share May Report Basic EPS and Diluted EPS

35 Options, Rights, and Warrants Proceeds Used to Purchase treasury shares At average market price The treasury stock method assumes that proceeds from the exercise of options are used to purchase treasury shares. This method usually results in a net increase in shares included in the denominator of the calculation of diluted earnings per share. The treasury stock method assumes that proceeds from the exercise of options are used to purchase treasury shares. This method usually results in a net increase in shares included in the denominator of the calculation of diluted earnings per share.

36 Options, Rights, and Warrants 1.Determine new shares from assumed exercise of stock options 2. Compute shares purchased from the treasury. 2. Compute shares purchased from the treasury. 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 exercise Average-of-period market price of stock Proceeds from assumed exercise Average-of-period market price of stock Illustration 19-9 (Page 202): Stock Options Exercise & 19-16

37 Options, Rights, and Warrants When the exercise price exceeds the market price, the securities are antidilutive and are excluded from the calculation of diluted EPS.

38 Convertible Securities The if-converted method is used for Convertible debt and equity securities. The if-converted method is used for Convertible debt and equity securities. The method assumes conversion occurs as of the beginning of the period or date of issuance, if later.

39 Restricted Stock Awards Restricted stock awards are quickly replacing stock options as the share-based compensation plan of choice. Like stock options, the treasury stock method is used to calculate the number of shares in the denominator of the EPS equation. Unlike stock option, employees do not pay to acquire their shares of stock. No adjustment to the numerator Denominator is increased using treasury method

40 Summary

41 Summary

42 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

43 Appendix 19A – Option-Pricing Theory Intrinsic value is the benefit the holder of an option would realize by exercising the option rather than buying the underlying stock directly. An option that permits an employee to buy $25 stock for $10, has an intrinsic value of $15. Options have a time value because the holder of an option does not have to pay the exercise price until the option is exercised.

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

45 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).

46 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 value of a stock option with similar terms.

47 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.

48 End of Chapter 19


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