2. Intermediate Financial Accounting Stock-Based Compensation Plans

3. 2 n Examples of Stock–Based Compensation Plans: n Stock Award Plans – Restricted Stock n Employee Stock Option (ESO) Plans n Stock Appreciation Rights (SAR) n Employee Stock Purchase Plans (ESPP)

4. Stock-Based Compensation Plans3 Common Goal and Accounting for These Plans n Employers’ Goal of these plans: to provide performance-based compensation to employees. n Accounting treatment: 1) to determine the fair value of the compensation, and 2) to expense this compensation over the vesting period of the compensation.

5. Stock-Based Compensation Plans4 Stock Award Plans n A grant of shares of stock to executives with some restrictions: 1)conditioned on continuing employment; 2)subject to forfeiture if employment is terminated before shares are vested; 3)cannot be sold before shares are vested.

6. Stock-Based Compensation Plans5 Stock Award Plans (contd.) n These restrictions provide the employees incentive to remain with the company until the restrictions are lifted. n Fair value of the restricted stock award: n the market value of the same stock (unrestricted) at the grant date. n The value is accrued as compensation expense over the vesting period (from the grant date to the date the restrictions lifted).

7. Stock-Based Compensation Plans6 Stock Award Plans -Example n Maple Co. grants one million of its $1 par common shares to its top five executives on 1/1/20x5. The shares are subject to forfeiture if employment is terminated within three years. Similar shares (unrestricted) have a current market price of $30 per share.

8. Stock-Based Compensation Plans7 Stock Award Plans -Example (contd.) n 1/1/20x5: No entry. The total fair value of the restricted shares is: $30 x1 million= $30 million. n $30 million compensation is to be allocated to expense over the vesting period of 20x5-20x7. n The annual allocated stock award plan compensation expense is: $30/3=$10 million.

9. Stock-Based Compensation Plans8 Stock Award Plans –Example (cont.) n J.E. for 12/31/20x5, 20x6 and 20x7 ($in millions):* n Compensation Expense 10 Paid-in Capital – restricted stock 10 n J.E. on12/31/20x7 (when restrictions are lifted): Paid-in Capital-restricted stock 30 Common stock ($1 par) 1 Paid-in capital – in excess of par 29 * any market price changes after the grant date would not affect the compensation expense.

10. Stock-Based Compensation Plans9 Stock Award Plans – Example with forfeiture n Assumed that 20% of the restricted shares are forfeited on 3/5/20x7 due to termination of employment, related entries would be reversed: ( $in millions) Paid-in capital – restricted stock 4 Compensation expense 4 to reverse 20% of comp. expense recog. in 20x5 and 20x6 12/31/20x7(to record comp. exp. of 20x7) Compensation expense 8 Paid-in Capital-restricted stock 8

11. Stock-Based Compensation Plans10 Stock Award Plans – the tax issue n The stock award plans are usually designed to comply with IRS codes to allow tax defer for the recipients until the shares are vested (i.e., when restrictions are lifted). n Likewise, companies receive no tax deduction of the compensation expense until the recipients are taxed for the stock award.

12. Stock-Based Compensation Plans11 Employee Stock Option Plans n Corporations have programs that enable employees to acquire shares of stock, often at a price equal or less than the current market price. n These programs involve the issuance of options (rights) to the employees and are referred to as employee stock option (ESO) plans.

13. Stock-Based Compensation Plans12 ESO Plans (contd.) n Non compensatory ESO Plans: This is a plan to raise capital or to obtain widespread employee ownership of the corporate stock rather than to provide additional compensation for certain employees.  The following characteristics are essential for a stock option plan to be qualified as “noncompensatory”:

14. Stock-Based Compensation Plans13 ESO Plans:(contd.) 1. All full time are employees who meet limited employment qualification are able to participate in the plan. 2. Stock is offered on an equal basis or an a basis related to a uniform percentage of salaries. 3. The exercise period is reasonable. 4. The discount is not greater than what would be in an offer of stock to stockholders.

15. Stock-Based Compensation Plans14 ESO Plans:(contd.) n If all four are met, no journal entry is required to recognize the value of the plan as compensation expense because no compensation is considered to be paid.  A memo is required.

16. Stock-Based Compensation Plans15 Compensatory ESO Plans n An ESO plan does not have all four characteristics listed in the preview section is a compensatory plan. n A compensatory stock option plan is to provide additional compensation to employees.

17. Stock-Based Compensation Plans16 The Value of ESO n This additional compensation is represented by the realized value of the ESO. n This realized value of ESO is the difference between the amount of proceeds received from the employees’ exercise of stock options and the amount of the proceeds which the corporation could receive if the stock were issued on the open market.

18. The Value of ESO (contd.)  This realized value of the ESO will not be known until the exercise date of the options.  However, this value is needed for the recognition of compensation expense during the vesting period.  As a result, this value of ESO needs to be estimated, usually, on the grant date of the options. Stock-Based Compensation Plans17

19. The Estimation of ESO Value: the Intrinsic Value method vs. the Fair Value Method  The Intrinsic Value Method (adopted by APB 25): t he value of the ESO is the excess of the market value of the share over the exercise price on the measurement date.*  The Fair Value Method (recommended by SFAS 123 and adopted by SFAS 123 (R)) : the value of ESO is estimated based on an option pricing model. * The date when both the exercise price and the number of options granted are first known which is usually the grant date. Stock-Based Compensation Plans18

20. Total Deferred Compensation Cost of the ESO  The total additional compensation cost represented by the granted ESO is the per share value of the ESO times the total numbers of options granted.  This total deferred compensation cost is amortized and recognized as an expense over the vesting period.* * The service period required for the option to be vested (i.e., from the grant date to the first date in which options can be exercised. Stock-Based Compensation Plans19

21. Stock-Based Compensation Plans20 Compensatory ESO Plans – An Example Using the Intrinsic Value Method n Assume that on 12/31/x2, a corporation grants A. Paul the nontransferable right to acquire 1,000 shares of $10 par common stock for $27 per share. n The market price on the date (12/31/x2) is $29 per share, and the service period is 4 years. n The stock option may not be exercised until the service period expired and the rights terminate at the end of 7 years or if Paul leaves the corporation.

22. Stock-Based Compensation Plans21 Intrinsic Value Method Example (Contd.) n J.E. 12/31/x3 Compensation expense 500 a Paid-in capital- ESO 500 a. ($29-27) x 1,000 = $2,000; $2,000/4 = $500 The compensation expense is also recognized for x4,x5 and x6 service years: J.E. for 12/31/x4,x5 and x6: Compensation Expense500 Paid-in capital –ESO 500

23. Stock-Based Compensation Plans22 Intrinsic Value Method Example (Contd.) n When the options are exercised on 3/6/x8, the following J.E is recorded: Cash ($27 * 1,000)27,000 Paid-in capital-ESO 2,000 Common Stock ($10*1,000)10,000 Additional Paid-in Capital19,000  Disclosure on the Balance Sheet (Year x3): Contributed Capital: paid-in Capital-ESO 500

24. Stock-Based Compensation Plans23 Intrinsic Value Method Example (Contd.) n If 500 shares of vested stock options were expired (due to market price fall below the exercise price) on 1/1/x9, the following entry will be recorded: Paid-in capital-ESO 1,000 Paid-in capital from expired options 1,000 n Note: when stock options expired, the previously recognized compensation expense is not adjusted.

25. Stock-Based Compensation Plans24 Intrinsic Value Method Example (Contd.) n If options are forfeited because an employee fails to satisfy a service requirement (i.e., leaves employment), the related entry is reversed as: n Paid-in capital – ESO $$$* Compensation expense $$$ * $$$ = The value of the forfeited options recognized in previous years.

26. Stock-Based Compensation Plans25 Intrinsic Value Method Example (Contd.) n The remaining ESO compensation cost (subtracting the value of forfeited options) would be allocated over the remaining service (vesting) period.

27. Stock-Based Compensation Plans26 The Fair Value Method (SFAS No. 123): Effective for fiscal year beg. after 12/15/1995  Under the intrinsic value method, when setting the option price equals the market price of the stock on the grant date, the intrinsic value of the option would be zero.  Thus, companies can avoid the recognition of compensation expense by setting the option price equals the market price.

28. Stock-Based Compensation Plans27 The Fair Value Method (SFAS 123)  Based on available stock option pricing models, the fair value of ESO can be estimated on the grant date.  Factors needed for the option pricing model: exercise price, expected term of the option (the time value), current market price of the stock, expected dividends, expected risk-free rate and expected volatility of the stock.

29. Stock-Based Compensation Plans28 The Fair Value Method (SFAS 123) (contd.) n Using the fair value method, the fair value of ESO is estimated based on an option pricing model and would be allocated over the vesting period. The journal entries are similar to those of the intrinsic value method as follows: n Compensation Expense xxx Paid in capital – ESO xxxx

30. Stock-Based Compensation Plans29 The Exercise, the Expiration and the Forfeitures of Vested ESO under the Fair Value Method n The treatment for the exercise of ESO is the same as that of the intrinsic value method on p22. n The treatment of the expired vested ESO is the same as that of the intrinsic value meth. on p23. n The treatment of the forfeitures of ESO is the same as that of the intrinsic value method on p24 and p25.

31. Stock-Based Compensation Plans30 The Fair Value Method n Using the fair value method, the estimated compensation cost is not calculated as the difference between the option price and the market price of shares on the grant date. Rather, it is based on an option pricing model. n Thus, the option value would not be zero even setting the option price equals the market value o n the grant date.

32. Stock-Based Compensation Plans31 The Emergence of the Fair Value Method in the Early 1990s n The public began to be more aware of the executive compensation in the form of stock options at the beginning of the1990s. n It is apparent that under the intrinsic value method, the ESO compensation expense is undervalued,and therefore, under-expensed.

33. Stock-Based Compensation Plans32 The Emergence of the Fair Value Method (cont.) n With the encouragement from both the SEC and the Congress, the FASB moved forward with its stock option project. n The FASB issued the Exposure Draft requiring the fair value method for the ESO accounting in 1993.

34. Stock-Based Compensation Plans33 The Emergence of the Fair Value Method (cont.) n The FASB encountered strong opposition toward the fair value method on ESO from many sectors of the society (i.e., the corp. executives, the auditors, members of the Congress, the SEC, etc.). n The main objection reasons provided by the critics iuclude:

35. Stock-Based Compensation Plans34 The Emergence of the Fair Value Method (cont.) n 1. ESO with no intrinsic value should have no fair value; n 2. It is impossible to estimate the fair value of ESO; n 3. The fair value method would have unacceptable economic consequences. n Note: The fair value method does not have any cash flow impact.

36. Stock-Based Compensation Plans35 The Emergence of the Fair Value Method (cont.) n As a result of the strong opposition, the FASB modified its position on the fair value method. n Under the pressure, the FASB allowed companies to choose between the intrinsic value method and the fair value method to account for the ESO compensation expense in SFAS 123.

37. Stock-Based Compensation Plans36 SFAS 123- Accounting for Stock-Based Compensation n SFAS 123, however, requires companies which choose the intrinsic value method disclose the pro-forma net income and earnings per share as if the fair value method were used. n Note: SFAS 123 was issued in 10/1995 and effective for fiscal year begninning after 12/15/1995.

38. Stock-Based Compensation Plans37 SFAS 123 ( R ) (issued in 2004 and effective for fiscal year beginning after 6/15/2005 n SFAS 123 (Revised 2004) mandates companies to use the fair value method to account for ESO expense. n The intrinsic value method is eliminated by SFAS 123 (R). n Prior to 2002, only two companies volunteered to expense ESO compensation at the fair value method

39. Stock-Based Compensation Plans38 The Emergence of the SFAS 123 ( R ) n The accounting scandals (i.e., fraudulent reports) of the high-profile companies lead to some degree of public consensus that the greed of the executives is a contributing factor to those misleading reports.

40. Stock-Based Compensation Plans39 The Emergence of the SFAS 123 ( R ) n With the proliferation of stock options granted to executives, the executives have more incentive to produce fraudulent reports to increase their stock price. n When stock price is increased, the executives’ compensation would also be increased from exercising their stock options.

41. Stock-Based Compensation Plans40 The Emergence of the SFAS 123( R ) n Thus, not expensing the ESO cost based on the fair value may have contributed to the earnings inflation.

42. Stock-Based Compensation Plans41 The Emergence of the SFAS 123 ( R ) n With this renewed interest in expensing the employee stock option at the fair value from the public, the FASB proposed and issued SFAS 123 (R) in 2004 to require the expense of employee stock option at the fair value, eliminating the intrinsic value method. n By the end of 2004, hundreds of firms were voluntarily expensing ESO at the fair value.

43. Stock-Based Compensation Plans42 Fair Value Method and Backdating of Employee Stock Options n Had the fair value method been required, it may have reduced (not eliminated) the magnitude of option backdating. n This is because the fair value method would require companies to recognize compensation expense even if setting the option price equals the market price on the grant date.

44. Stock-Based Compensation Plans43 Incentive Stock Option Plans Vs. Non-qualified stock option plans-tax issues n A compensatory option plan can be an incentive stock option plan or a non- qualified stock option plan based on the IRS code.  Under an Incentive Stock Option Plan: The employee neither pay tax on the grant date nor on the exercise date of the options. T he employee defers the tax payment until shares acquired through the ESO are subsequently sold.

45. Stock-Based Compensation Plans44 Incentive Stock Option Plans- tax issues  The company which grants the options gets no tax deduction at all.  To qualify as the incentive plan under the Tax Code, one important requirement is that the option price has to be equal to the market price on the grant date. 

46. Stock-Based Compensation Plans45 Advantages of Setting Exercise Price Equals the Market Value n Avoid expensing the compensation cost if the intrinsic value method is adopted; and n qualify as an incentive plan for tax purposes.

47. Stock-Based Compensation Plans46 Non-qualified stock option plans-tax issues  Under a Non-qualified Stock Option Plan: The option price can be set to below the market price on the grant date. The employee has to pay tax on the exercise date when exercise price is less than the market price on the exercise date (i.e., no tax defer). The company can deduct the difference between the exercise price and the market price on the exercise date for tax purposes.

48. Stock-Based Compensation Plans47 Why Do Companies Offer Incentive Option Plans ?  Since the non-qualified stock option plan favors the company for tax purposes, why would some companies structure the plans as incentive plans?

49. Stock-Based Compensation Plans48 Why Do Companies Offer Incentive Option Plans ?  Two possible reasons:  No recognition of compensation expense since option price sets to equal the market price under the incentive plan (only when the intrinsic value method is allowed)  The favorable tax treatment for the recipients of options under the incentive plan can better attract and retain quality employees than the non-qualified plan.

50. Stock-Based Compensation Plans49 Tax Consequences of Stock-Based Compensation Plans-the Incentive Plan  For the incentive plan, the companies receive no tax deductions at the exercise date.  Thus, there is no tax consequences for the companies under the incentive stock option plan.

51. Stock-Based Compensation Plans50 Tax Consequences of Stock-Based Compensation Plans-the non-qualified plan  For the non-qualified stock option plan, the companies will receive tax deductions on the exercise date for the difference between the option price and the market price on the exercise date.  Thus, there would be tax consequences for the non-qualified plan.

52. Stock-Based Compensation Plans51 Tax Consequences of Stock-Based Compensation Plans –the non-qualified plan (contd.)  Since the compensation expense 1 is allocated over the service period starting the granting year while the tax deduction 2 is not allowed until the exercise date, this will create a temporary difference between accounting income and taxable income.

53. Stock-Based Compensation Plans52 Tax Consequences of Stock-Based Compensation Plans –the non-qualified plan (contd.) 1.The difference between the option price and the market price on the grant date. 2. the difference between the option price and the market price on the exercise date.

54. Stock-Based Compensation Plans53 Tax Consequences of Stock-Based Compensation Plans –the non-qualified plan exapmle  use the information on page 20 except that the company adopts the fair value method. The estimated fair value of the option per share equals $4 using an option pricing model. Also, assume a tax rate of 40%. The following entries will be recorded for x3,x4,x5 and x6: Compensation expense 1,000 1 Paid-in capital-stock options 1,000 Deferred tax asset 400 Income tax expense 400 1. $4*1,000 /4 service years= $1,000

55. Stock-Based Compensation Plans54 Tax Consequences of Stock-Based Compensation Plans –the non-qualified plan exapmle (contd.) When all options are exercised in March of x8, and the market price is $33 per share, the following entries are recorded: Cash ($27 * 1,000)27,000 Paid-in capital-stock options 4,000 Common Stock ($10*1,000)10,000 Additional Paid-in Capital 21,000 Income tax payable 2,400 Deferred tax asset 1,600 Paid in capital-tax effect on stock options 800

56. Stock-Based Compensation Plans55 Tax Consequences of Stock-Based Compensation Plans –the non-qualified plan exapmle (contd.) When all options are exercised in March of x8, and the market price is $30 per share, the following entries are recorded: Cash ($27 * 1,000)27,000 Paid-in capital-stock options 4,000 Common Stock ($10*1,000)10,000 Additional Paid-in Capital 21,000 Income tax payable 1,200 Income tax expense or paid-in capital-tax effect 400 Deferred tax asset 1,600

57. Stock-Based Compensation Plans56 Plans with Performance on Market Conditions n Conditions to vest an ESO are not limited to the service years. n Other conditions could be: Performance-based: certain performance must be met (i.e., EPS increased by 10%; sales growth 20% every year for three years, etc.). Market-based: stock price increased by 20% in three years.

58. Stock-Based Compensation Plans57 Plans with Performance on Market Conditions: accounting (contd.) n Recognition of the compensation exp. of the performance-based depends on: n Initially on whether the performance target could be met ; n Ultimately on whether the target is actually met.

59. Stock-Based Compensation Plans58 Plans with Performance on Market Conditions: example I n Cgate Corp. estimated the ESO expense at a fair value of $100 million with a 4-year vesting period. For 20x5 and 20x6, Cgate recorded the ESO expense based on the expectation that the performance target can be achieved: JE for 20x5 and 20x6 ($ in millions) Compensation Expense 25 Paid-in Capital –Stock Options 25 n In 20x7, the expectation is that it is not probable to achieve the performance target: Paid-in Capital –Stock options 50 Compensation Expense 50

60. Stock-Based Compensation Plans59 Plans with Performance on Market Conditions: example II n Cgate Corp. estimated the ESO expense at a fair value of $100 million with a 4-year vesting period. For 20x5 and 20x6, Cgate recorded the ESO expense based on the expectation that the performance target cannot be achieved: n JE for 20x5 and 20x6: ($ in millions) Compensation Expense 0 Paid-in Capital –Stock Options 0

61. Stock-Based Compensation Plans60 Plans with Performance or Market Conditions: example II (contd.) n In 20x7, the expectation is that it is probable to achieve the performance target: Compensation Expense 75* Paid-in Capital – Stock Options 75 * $100 x ¾ - $0 = $75 Note: The cumulative effect on compensation is reflected in 20x7 earnings, not as a prior period adjustment. n The JE in 20x8 (no change in estimation): n Compensation Expense 25 Paid-in Capital-Stock Options 25

62. Stock-Based Compensation Plans61 The Traditional ESO Plans vs. Performance-based ESO Plans n For the traditional ESO plans, the fair value of ESO is estimated at the grant date and is allocated as comp. expense over the vesting period. n The allocation of fair value is not affected (or reversed) even if the expectation (about whether the market price will exceed the exercise to ensure the exercise of the options) is changed.

63. The Traditional ESO Plans vs. Performance-based ESO Plans (cont.)  For the performance-based plans, the previously recognized compensation expense and paid-in capital- ESO would be reversed when the expectation (about whether the performance target can be achieved) is changed. Stock-Based Compensation Plans62

64. Stock-Based Compensation Plans63 The Traditional ESO Plans vs. Performance-based ESO Plans (contd.) n If the vested traditional option becomes worthless, the paid-in capital-stock option is debited and paid-in capital from expired option is credited, not the compensation expense.

65. Stock-Based Compensation Plans64 The Traditional ESO Plans vs. Performance-based ESO Plans (contd.) n For the performance-based plans, if the option expected to be worthless (i.e., expecting the target performance not being met), the previously recognized paid-in capital-stock option will be debited and compensation expense will be credited.

66. The Traditional ESO Plans vs. Performance-based ESO Plans (contd.)  Some companies favor the performance-based ESO plans over the traditional ESO plans due to its lower compensation expense in the case of performance target not being met. Stock-Based Compensation Plans65

67. Stock-Based Compensation Plans66 Stock Appreciation Rights (SARs) n Under either incentive or the non-qualified stock option plan, the employee has to come up with cash to exercise the options (and pay the tax under the non-qualified option plan). n Stock Appreciation Rights (SARs) is a creation to solve the cash problem for employees with the stock-based compensation.

68. Stock-Based Compensation Plans67 The Stock Appreciation Rights(SARs) n The SARs are rights granted to key employees that enable them to receive cash, stock or a combination of both equal to the share appreciation (i.e., the excess of the market price on the exercise date over a pre- specified price, usually the share price on the grant date). n The value of SARs is estimated based on an option pricing model.

69. Stock-Based Compensation Plans68 The SARs: an Example On 1/1/x4, when the market price is $10 per share, a corp. grants 1,000 SARs to a key executive, C. Talbert. Under the SARs Plan, Talbert is entitled to receive cash or stock for the difference between the market price at exercise and a $10 for 1,000 shares of the company stock on the date of exercise. The service period is 4 years (x4-7) and the rights must be exercised in 6 years (x8-9).

70. Stock-Based Compensation Plans69 SAR Example (Contd.) n The year and fair values of SAR per share are shown in Exhibit 1. Talbert exercises the rights to receive cash on 7/9/x8 when the stock price is $13.4 per share.

71. Stock-Based Compensation Plans70 Stock Appreciation Rights(SARs) (Contd.) 12/31/x4Compensation Expense500 Liability- SAR plan 500 12/31/x5Compensation Expense1,000 Liability – SAR plan 1,000 12/31/x6Liability – SAR plan 150 Compensation Expense 150 12/31/x7Compensation Expense 1,250 Liability – SAR plan 1,250 Note: a paid-in capital –SARs plan account should be credited if Talbert can only elect to settle in shares at exercise. When an equity account is credited, the fair value of SARs is not reevaluated over the vesting period.

72. Stock-Based Compensation Plans71 Stock Appreciation Rights(SARs) (Contd.) Liability –SAR plan 200 500 1,000 1,300 2,600…. 12/31/x7 J.E. of 7/19/x8 when Talbert exercises the option: Comp. Expense 800 Liability –SAR plan 2,600 Cash 3,400

73. Stock-Based Compensation Plans72 Employee Share Purchase Plans (ESPP) n The employee share purchase plans permit all employees to buy shares directly from their companies at favorable terms (i.e., no commissions or at a discount, etc.).

74. Stock-Based Compensation Plans73 Employee Share Purchase Plans (ESPP) n If, a) substantially all employees participate in the plan; b) employees have no longer than one month to decide to participate; and c) the discount is not greater than 5%, the accounting treatment for the ESPP is similar to the sale of shares to employees. n This plan is a non-compensatory plan and no compensation expense is recognized by the employer.

75. Stock-Based Compensation Plans74 Employee Share Purchase Plans (contd.) n If the employers pay a portion of the purchase price, the compensation expense account is used for the portion of purchase price paid by the employer. J.E. is as follows: n Compensation Expense $$ * Cash $$ Common Stock $$ Paid-in capital $$ *The portion of the purchase price paid by the employers.

76. Stock-Based Compensation Plans75 Employee Share Purchase Plans n In case of discount is greater than 5% (i.e., a 15% discount) and no reasonable justification for this discount, the purchase plan will be treated as a compensatory plan. n The value of this 15% discount will be recognized as compensation expense when the employees purchase shares at the 15% discount.