© 2006 ernst & young llp. all rights reserved. for internal use within e&y only; not for...

© 2006 Ernst & Young LLP. All rights reserved. For Internal Use Within E&Y Only; Not for Distribution to Clients.

Everything You Ever Needed To Know About Stock Compensation & More

Conference of Consulting Actuaries MeetingSession 46 - October 24, 2007

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Your Presenter

• Bill MurphyBill Murphy– North Central Sub-Area North Central Sub-Area

Location Leader, Performance Location Leader, Performance & Reward& Reward

– Senior Manager, Ernst & Young Senior Manager, Ernst & Young

216-583-2869216-583-2869– [email protected]@ey.com

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Agenda

• Current trends in Stock-Based CompensationCurrent trends in Stock-Based Compensation

• Taxation of Equity AwardsTaxation of Equity Awards

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• Non-Qualified Stock Options (NQSO)– Right to purchase stock at a specified price for a specified period of time.

– Value is based on the appreciation in the underlying stock from the date of grant to the date of exercise.

– Does not meet specific tax requirements of Internal Revenue Code (IRC) Sections 421-4222.

• Restricted Stock/Restricted Stock Units (RS/RSU)– Shares (or share units) granted to employee, typically subject to vesting restrictions.

– Shares retain some value even if stock price declines.

– Difference: Restricted stock is transferred to the participant on the date of grant. Restricted Stock Units are promises to deliver the stock on the vesting date.

• Stock Appreciation Rights (SAR)– Right to receive stock (or cash payment) equal to the appreciation of company shares between

the date of grant and the date of “exercise”.

– Similar to stock options, but SARs do not require the payment of an exercise price, and may be structured to prevent actual share ownership (which may give rise to financial statement implications discussed in more detail later).

Primary Stock Based Incentive Vehicles

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Plan Design Issues and Considerations• Appreciation v. Full Share Awards – Should the company

limit the value to appreciation from the date of grant?

• Time-based or Performance-Based Vesting – Should vesting be based on continued service or achievement of some company performance conditions?

• Fixed Grant or Variable Grant – Should the number of awards be fixed up front (e.g., time-base vested awards), or should performance dictate the ultimate size of the award?

• Executive Stock Ownership – Does the company have share ownership guidelines for its executives and what awards count towards those goals?

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Plan Design Issues and Considerations

• Shares Available for Grant (Number and Full Share v. Appreciation Awards) – Companies need to consider shares remaining available under the stock plans and stock plan limitations when planning grants, and institutional shareholder considerations on shares reserved, share value transfer, and burn rates.

• Tax Impact – Companies need to consider tax laws not just in the U.S. but in each international jurisdiction to determine most efficient stock vehicle from a tax perspective.

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Plan Design Issues and Considerations• Accounting Implications – Companies need to

consider the potential financial statement implications of the awards.

• Institutional Shareholder/Disclosure Implications – What are key shareholders focusing on in equity plan design?

• Administrative Considerations – Sometimes overlooked. How difficult will it be to administer the plan? Not just from an HR perspective, but in getting appropriate information for accounting, tax, etc.

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Current Trends in Stock CompensationPORTFOLIO APPROACH

• Companies continue to shift from “stock options only” culture towards a “portfolio of stock vehicles” for annual stock based grants.

• Companies are increasingly relying on restricted stock/restricted stock units to deliver their stock-based compensation opportunity.

PERFORMANCE CRITERIA

• With shareholders increasingly focused on performance, more companies are beginning to utilize performance-based vesting/performance-based awards.

• Accounting rules (along with shareholder emphasis on performance) continue to fuel this trend in that performance-contingent awards are no longer subject to adverse accounting treatment as compared with service-based awards.

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Performance-Based Compensation• There has been an increased shareholder focus on compensation that

is more closely linked to company performance.

– Performance goals can relate to achievement of absolute or relative performance metrics.

• Absolute– Examples: Revenue growth, Operating Income growth, Earnings Per Share,

Return on Investment.– Goals are focused on the performance of the company solely.

• Relative– Examples: Total Shareholder Return (TSR) and stock price appreciation

relative to a group of companies or industries, or revenue growth against revenue growth of a peer group.

– Goals are focused on the performance of the company compared to other companies.

– Whether a condition is classified as “performance condition” or “market condition” has significant consequences to the award valuation at the date of grant as well as the manner in which the compensation cost is recognized.

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Performance Conditions• A performance condition may be a condition that is based on the

operations or activities of the employer that are not driven by stock price/TSR, etc. The condition may relate to the performance of the entire company, a division, or an individual employee.

• A performance condition may also be in reference to the same performance measure of another entity or group of entities (e.g., growth of EPS relative to other entities in the employer’s industry)

– Example: The Board of XYZ Corporation (NYSE: XYZ) recently approved the award of performance vesting restricted stock units. The award provides participants with the opportunity to receive shares if the Company's compounded annual growth rate on revenue during a three-year performance period is equal to or exceeds the Company's peer group median.

If the performance goal is met, the restricted stock units cliff vest three years from the grant date. Failure to meet the performance goal results in forfeiture of shares.

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Market Conditions• The exercisability or other terms of a stock award may be dependent on

achieving a specified stock price or a specified return on the stock price (e.g., price appreciation plus dividends). FAS 123(R) refers to such conditions as market conditions.

• Examples of market conditions would include those in which exercisability is dependent on or other terms are affected by:

• The employer’s stock price achieving a specified level.

• Achieving a specified return on the employer’s stock, the calculation of which is based on both stock price appreciation and dividends on the stock.

• The employer’s stock price increasing by a greater percentage than the average increase of the stock price of a group of peer companies.

• A specified stock return, which is based on both stock-price appreciation and dividends on the stock that exceeds the average return on the S&P 500.

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Key Differences Between Performance & Market Conditions.• For awards with a performance condition, compensation

expense is reversed for awards that do not vest (similar to awards with service conditions). In contrast, compensation expense is not reversed for awards with a market condition, provided the requisite service has been rendered.

• For awards with a performance condition, the valuation is similar to awards with service conditions (i.e., the performance condition is not incorporated into grant date fair value calculation). However, market conditions need to be factored in the valuation of awards through the use of a lattice model or Monte Carlo simulations.

AABS Global Learning

James LecherAssistant Vice President

FAS 123 Valuations

AABS Global Learning14

Development of Valuation Assumptions

Regardless of the valuation model chosen correct assumption development is extremely important to develop accurate fair values. “Garbage in Garbage out” is very applicable in option valuation.

FAS 123(R) states the valuation models must at a minimum take into account the following assumptions.

* The expected life is an input to the Black-Scholes Model. In a lattice model probabilities of exercise are input into the valuation model and the expected life is a biased estimate that is an output of the model.

Required Option Pricing AssumptionsGrant Price Risk-Free Rate of ReturnExercise Price Expected Dividend Yield Stock Price Volatility Expected Life*


Expected Life Considerations

Factors to consider include:- Simplified Approach from SAB 107- Vesting period and contractual term- Historical patterns of exercise and post-vesting termination- Changes in Option Characteristics (i.e. vesting or term)- Expected Volatility- Optionee Demographics

Age/Gender/Country/Job Level Stratification

- Peer Companies- Censored Data and assumptions about outstanding options

Minimum at Vesting Maximum at Term Most likely may be the midpoint of future remaining term


Expected Life – Emerging Best PracticeExpected Life – Emerging Best Practice

Courtesy of FAS123R Data in SEC Filings as Provided by Salary.com

0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00

Consumer Discretionary

Consumer Staples

Energy

Financials

Health Care

Industrials

Information Technology

Materials

Telecommunication Services

Utilities

Total

Sec

tor

Term (Years)

Current Year Prior Year




Current Year Prior YearTotal Standard Total Standard

Sector Companies Deviation Average Companies Deviation AverageConsumer Discretionary 1 411 1.59 5.05 466 1.72 5.17Consumer Staples 2 77 1.88 5.47 89 1.99 5.53Energy 3 110 1.99 5.03 128 2.11 5.19Financials 4 632 2.17 6.14 671 2.23 6.38Health Care 5 345 1.71 4.78 393 1.73 4.83Industrials 6 273 1.70 5.30 322 1.77 5.36Information Technology 7 462 1.58 4.15 518 1.66 4.19Materials 8 93 2.12 5.57 103 2.10 5.50Telecommunication Services 9 38 1.92 4.82 44 1.80 5.13Utilities 10 44 2.26 5.69 68 2.21 6.45Total 2,485 2.00 5.26 2,802 2.07 5.37



The most common approach (58%) is to assume currently outstanding options will be exercised at the midpoint of the future remaining term.

The “Simplified Approach” as outlined in SAB #107 is also popular. It can be calculated from historical data or, in the absence of historical data, can be calculated using the vesting schedule and the full contractual term.


Expected Volatility - Considerations

Factors to consider include:- Historical volatility

Period of Measurement (short term vs. mid-term vs. theory of mean reversion)

Removal of data?

- Implied volatility Liquidity – Open Contract vs. Trading Volume? Historical Implied Volatilities?

- Peer companies - especially for companies with little history

- Blended Volatilities – Developing supportable weights


Expected Volatility – Emerging Best Practice

Current Year Prior YearTotal Standard Total Standard

Companies Deviation Average Companies Deviation AverageConsumer Discretionary 1 411 17.74% 43.54% 466 20.21% 47.42%Consumer Staples 2 77 18.33% 37.78% 89 20.83% 39.81%Energy 3 110 16.51% 43.64% 128 19.75% 45.51%Financials 4 632 12.10% 27.47% 671 14.05% 28.32%Health Care 5 345 23.25% 56.53% 393 26.52% 61.64%Industrials 6 273 23.23% 43.10% 322 32.10% 46.15%Information Technology 7 462 21.66% 60.83% 518 26.76% 71.25%Materials 8 93 15.26% 37.76% 103 15.73% 39.42%Telecommunication Services 9 38 32.26% 57.50% 44 33.90% 62.33%Utilities 10 44 16.84% 27.81% 68 16.37% 30.69%Total 2,485 22.67% 43.61% 2,802 27.53% 47.80%



Employee Stock Options Valuation Models

Common Stock Option Pricing Models

- Black-Scholes Model

- Binomial Models

- Simulation Models

Each Model has pros and cons with respect to accuracy, ease of application, and modeling flexibility.

Regardless of the model used FAS 123(R) specifies that all of the following assumptions must be used to calculate the grant date fair value of an equity award.

Required Option Pricing AssumptionsGrant Price Risk-Free Rate of ReturnExercise Price Expected Dividend Yield Stock Price Volatility Expected Life*


Black-Scholes Formula - Pros and Cons

The Black-Scholes model offers the following advantages / disadvantages for FAS 123(R) purposes.

Pros ConsClosed Form Model No Yield Curves - Interest Rates, Volatility, Dividend Yield

Static Assumptions Poor Exercise Distribution

Widely Available for Download Only Based on Time After Grant

Companies With Little Historical Data Limited Historical Price Paths Can Give Erroneous Results

Ease of Audit


Black-Scholes Formula - Pros and Cons

Historical data from periods that had unusual stock price movements can cause anomalies in the Black-Scholes model. This is due to treating time after grant as the only driver of exercise.

Stock Price Option-Holding Monetary Black-Scholes Black-ScholesAppreciation Period Gain Input Fair - Value

Scenario 1 High Short High Low Low

Scenario 2 Low Long Low High High

Scenario 3 None Full Term None Highest Highest


Black-Scholes Formula – An Alternative Approach

Black-Scholes Call Value vs Time to Expiration

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Term

Per

cen

t o

f G

ran

t P

rice

Black-Scholes Value

Option pricing theory states that the fair value of an option increases at a decreasing rate as the term of the option increases. This causes the Black-Scholes Model to overstate the fair value by approximately 3% to 7% since all options are assumed to be exercised at one point in time.


Alternative: Multiple-Point Black-Scholes Improves Accuracy

Fundamental inaccuracy of traditional Black-Scholes is use of single-point expected life

- Collapses all expected exercise activity to one date- Paragraph A30 – “estimating the fair value of an option based on a single

expected term that effectively averages the differing exercise and post-vesting employment termination behaviors of identifiable groups of employees will potentially misstate the value of the entire award”

A multiple-point approach overcomes this problem- Utilizes actual historical exercise option data by individual- Can incorporate historical unexercised option data

A distribution of exercise activity is created- Each option is valued as a European option at its actual or assumed exercise

date- Creates weighting of results based on number of shares- Results are summed and averaged

Fair value will always be lower than traditional (i.e. single-point) Black-Scholes, as marginal value of option gets smaller with time


Examples: Multiple-Point Black-Scholes

CompanyFixed Point

Black-Scholes

Aon Multiple-Point Black-

ScholesError Term

Expected Life

Contractual Term Volatility

Dividend Yield

Standard Deviation Kurtosis

Company A 13.28% 12.26% -7.65% 4.29 10.00 16.11% 3.36% 2.3590 (0.3778)Company B 36.33% 35.14% -3.28% 5.84 10.00 35.04% 1.00% 2.3883 (0.9050)Company C 44.89% 43.29% -3.57% 4.89 10.00 46.46% 0.00% 2.2066 (1.0080)Company D 20.30% 19.19% -5.50% 4.77 10.00 25.11% 3.23% 2.4140 (1.0919)Company E 55.82% 54.28% -2.76% 5.05 10.00 61.06% 0.00% 1.8318 0.0940Company F 31.02% 30.30% -2.33% 6.19 10.00 22.98% 0.59% 1.8428 (0.5975)Company G 42.39% 40.53% -4.38% 4.07 10.00 47.19% 0.00% 2.1376 (0.6557)Company H 59.50% 56.28% -5.40% 5.26 10.00 64.71% 0.00% 2.4881 2.0704Company I 55.99% 53.77% -3.95% 4.74 10.00 63.45% 0.00% 2.0822 2.4096Company J 37.19% 36.80% -1.04% 3.61 5.00 43.00% 0.00% 1.0037 7.2713Company K 49.44% 48.02% -2.87% 3.91 7.00 60.78% 0.00% 1.5042 3.0813Company L 62.34% 59.27% -4.92% 5.11 10.00 70.77% 0.00% 2.1348 2.7479Company M 56.73% 54.31% -4.26% 5.81 10.00 56.44% 0.00% 1.9833 2.3470Company N 48.78% 44.90% -7.96% 3.81 10.00 59.95% 0.00% 2.4418 1.5674Company O 29.83% 29.38% -1.50% 4.93 6.00 29.38% 1.20% 0.8175 5.7420Company P 54.23% 52.06% -4.00% 5.30 10.00 57.30% 0.00% 2.2993 2.2516Company Q 43.17% 42.31% -1.99% 5.69 10.00 38.55% 0.00% 1.9894 2.6006Company R 67.55% 64.43% -4.61% 5.17 10.00 79.74% 0.00% 2.1908 2.6212Company S 17.02% 16.37% -3.87% 4.23 10.00 21.34% 3.20% 1.8860 2.5333Company T 28.65% 27.88% -2.67% 5.31 10.00 28.56% 1.65% 1.9172 2.3716Average 42.72% 41.04% -3.93% 4.90 9.40 46.40% 0.71% 1.9959 1.7537


Results: Multiple-Point Black-Scholes

Of the 20 companies, the fixed point Black-Scholes had an approximate 4% error term

Aon has observed that a fixed point Black-Scholes model creates the greatest error for companies that have the following characteristics:

- High Dividend Yields

- Short Historical Average Lives

- Large Standard Deviations of Exercise Behavior

- Small or Negative Kurtoses


Binomial Models

Two Types of Binomial Models

Barrier Model –

- Standard Binomial Model

- Cox, Ross, Rubinstein Binomial Model (CRR Model)

- Hull/White Binomial Model

Exercise Probability Model

-Regression Based Models

- Hazard Rate Based Models


Binomial Models

Barrier Models - The barrier models differ in how they assume that the option will be exercised. When the “Barrier is Broken” the option is exercised.

Time Based Barrier - Standard Binomial and CRR Binomial Model -These models are identical when there is no dividend. The fair values from these models will converge to the Black-Scholes model if small enough time

increments are used. -The CRR model is slightly more refined on a dividend paying stock. It allows for early exercise in instances where it would beneficial financially to exercise the option early. Stock Price Based Barrier - Hull/White Model - The Hull-White Model uses stock price as a barrier. - Several studies have shown that time after grant is a more significant than stock price as a driver of exercise. - This model is not considered to be as accurate as a time based barrier model by many FAS 123(R) practitioners.


Binomial Models

Exercise Probability Model

-Still in early stages of development

-Can use many drivers of exercise

- Time after grant, proximity to vesting, stock price appreciation, observed

historical volatility are seen at this time to be the most critical drivers of

exercise behavior.

- Regression models can be used but it may be difficult to capture the stock price

path dependent nature of employee exercises.

- Many believe that hazard rate modeling will be necessary for accurate

modeling.

- Currently the use of hazard rate modeling is being examined by a specialized

S.O.A. task force. The construction of standardized tables of exercise rates

is being studied.

-This would be similar in nature as the use of standardized rates of retirement,

termination, disability, and mortality are used for pension plan accounting

under FAS 87.


Black-Scholes and the Traditional Binomial Model

* Simplification such that there is an equal probability of downward and upward movements. This is not the case generally as the probability of upward and downward movements are governed by the volatility, the dividend yield, and the discount rate.

21 dNXedSNeC rtt

t

trXS

d

2

/ln2

1

tdd 12

Black-Scholes Traditional Binomial ModelProbability *

Illustration comparing closed-form Black-Scholes model with a traditional binomial model (present value of future cash flows)

S5,0

S4,0

S3,0 S5,1

S2,0 S4,1

S1,0 S3,1 S5,2

S0,0 S2,1 S4,2

S1,1 S3,2 S5,3

S2,2 S4,3

S3,3 S5,4

S4,4

S5,5

3.125%

15.625%

3.125%

31.25%

31.25%

15.625%


Binomial Models

Binomial option pricing models offers the following advantages/disadvantages for

FAS 123(R) purposes:

Pros ConsAssumptions Can Be Examined Easily Complicated to Calibrate

Can Use Term Structure of Risk-Free Rates, Volatility, Expensive and Time Consuming to Auditand Dividend Yield

Disclosure of the use of a Binomial ModelCan Incorporate Various Assumptions Such as Prevents the Use of Black-Scholes in the FutureProbabilities of Exercise, Termination, and Retirement


Simulation Models

Use to value exotic options that can not be valued with Black-Scholes or Binomial models.

Extremely flexible - Can be used to model extremely complex instruments.

Can capture correlation of stocks which is important when modeling relative performance plans.


Simulating Stock Price

The first step to any simulation valuation model is to simulate the stock price over the term of the option.

The most common technique is to use Geometric Brownian Motion. The underlying distribution of stock prices is log-normal with a drift coefficient.

Alternatively one can model the returns via a normal distribution which yields the identical price distribution as above.


Simulating the FAS 123(R) fair value - A Real-World Example – An absolute Performance Plan

Company ABC grants restricted shares that are subject to the following vesting schedule. TSR is defined as the total shareholder return assuming that all dividends are reinvested in the company stock.

The following economic assumptions will be used to calculate the grant date fair value:

Total Shareholder

Return Vesting Vesting "TSR" Price Percentage10.00% $55.00 25.00%20.00% $60.00 50.00%30.00% $65.00 100.00%

Valuation AssumptionsGrant Date 1/2/2007Grant Price $50.00Volatility 40.00%Risk-Free Rate 5.25%Dividend Yield 0.00%


Simulating the FAS 123(R) fair value - A Real-World Example - Continued

The following spreadsheet has been constructed to model this instrument:Meaurement Random Random Random Random Tranche 1 Tranche 2 Tranche 3

Period Time Uniform Normal Return Price Vests? Vests? Vests?0 0.00 0.7725 0.7470 $50.001 0.17 0.5301 0.0756 1.47% $50.742 0.33 0.0733 -1.4516 -11.00% $45.163 0.50 0.2023 -0.8336 -5.95% $42.474 0.67 0.1381 -1.0891 -8.04% $39.065 0.83 0.9406 1.5593 13.59% $44.376 1.00 0.1760 -0.9306 -6.74% $41.377 1.17 0.4927 -0.0182 0.71% $41.678 1.33 0.4017 -0.2490 -1.18% $41.189 1.50 0.5266 0.0666 1.40% $41.7510 1.67 0.7790 0.7686 7.13% $44.7311 1.83 0.9054 1.3129 11.58% $49.9112 2.00 0.6691 0.4373 4.43% $52.1213 2.17 0.7543 0.6880 6.47% $55.49 114 2.33 0.8151 0.8968 8.18% $60.03 1 115 2.50 0.3152 -0.4813 -3.07% $58.19 116 2.67 0.0285 -1.9027 -14.68% $49.6517 2.83 0.7389 0.6400 6.08% $52.6718 3.00 0.5716 0.1804 2.33% $53.89

Total Hurdle 1 Hurdle 2 Hurdle 3Vesting Vesting Vesting Vesting

Percentage Percentage Percentage Percentage50% 25% 25% 0%

Simulation ResultEnding Price $53.89

Payout $26.95PV Factor 116.59%PV Payout $23.11


Simulating the FAS 123(R) fair value - A Real-World Example - Continued

The prior sheets shows one iteration of this simulation. After re-simulating 250,000 times the model yields the following results:

Please note that the simulated fair value is NOT calculated by simply multiplying the grant price by the vesting percentage. Doing so would substantially understate the grant date fair value by ignoring the correlation between vesting events and stock prices.

Simulation ResultsSimulated Vesting Percentage 68.99%Simulated Payout $48.87Simulated PV Payout $42.35


Simulating Models – Pros and Cons

Pros ConsExtremely Flexible - Can Model Almost any Equity Instruments Computing Time

Can Use Term Structure of Risk-Free Rates, Volatility, Can be Time Consuming and Costly to Createand Dividend Yield

Programming Must be Checked Rigorously to Prevent ErrorsCan Incorporate Various Assumptions Such as Probabilities of Exercise, Termination, and Retirement

Simulation models offer the following advantages / disadvantages forFAS 123(R) purposes:


Current Modeling Trends


FAS123R Valuation: Model Use Comparison FAS 123 and FAS 123(R)

FAS123 - Valuation guidance requires use of the Black-Scholes or a binomial model - As of 2002, 5 companies of the S&P 500 used a binomial model

- Black-Scholes was generally perceived to overstate the value - Companies ignored the error term because it didn't affect earnings

FAS123(R) - Allows both Black-Scholes or binomial models, however states that the design of a lattice model more fully reflects the characteristics of an ESO-

- As of January 10, 2007, 402 companies have publicly disclosed the use of a binomial model (see Appendix A)

- 80 of those 402 companies that now use a binomial model are components of the S&P 500.


FAS123R Valuation: Binomial Adoption Year

As of 9/10/2007

0

50

100

150

200

250

300

350

400

450

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Fiscal Year of Adoption

Small (<$100M) Medium ($100M- $1B) Large ($1B - $5B) J umbo (>$5B)

watsonwyatt.com

FAS 123R Accounting Rules Overview

Steve Zwicker,Senior Consultant

Copyright © Watson Wyatt Worldwide. All rights reserved

43

Introduction / Agenda

This presentation provides an overview of the accounting rules under Statement of Financial Accounting Standards No. 123R – Share-Based Payment.

Topics are presented in the following main categories:

Measurement Issues

Attribution Issues

Tax Issues

Other Issues


44

Measurement Issues

Scope of Standard

Question

What plans are covered under the standard?

Answer

Employee share-based awards including options, stock appreciation rights, restricted stock and stock units, performance shares and employee stock purchase plans

Employee stock ownership plans are not covered


45

Measurement Issues

Scope of Standard

Question

Who is covered under the standard?

Answer

Employees as defined under common law Leased employees if certain requirements are met Directors are considered employees for Board services, but would be

treated as non-employees for any other services Subsidiary employees for parent company financial purposes Non-employee awards are not covered under FAS 123R, but will be

considered instead in a future FASB project


46

Measurement Issues

Equity versus Liability Awards

Question

What is the distinction between equity and liability awards?

Answer

Equity awards are those that are settled in shares Equity awards are generally measured at fair value at grant (fixed) Liability awards are generally those that are settled in cash or remove

the risk of stock ownership from participants Liability awards are re-measured at fair value at each reporting date

until they are settled (variable)


47

Measurement Issues


Question

What can result in liability classification?

Answer

FAS 123R calls for liability classification if the company can be required to settle in cash under any circumstances

Plans may allow for cash settlement in limited circumstances, such as a change in control

Not an issue if company has control over cash settlement FASB Staff Position FAS 123(R)-4 relaxed this provision and allows for

a probability test to be applied in determining award classification


48

Measurement Issues


Example

100 SARs granted on 1/1/2007 at $10 with one year vesting December 31, 2007 stock price is $15 SARs are exercised on July 1, 2008 at $20

Stock Settled Cash Settled

1/1/07 fair value $5.00 $5.00

12/31/07 fair value N/A $7.50

2007 expense $500 $750

2008 expense $0 $250


49

Measurement Issues

Grant Date

Question

How is grant date defined?

Answer

Grant dates occur when the company and employee have a mutual understanding of the key terms and conditions (T&Cs)

This is generally the date when fair value expense is measured Often, a grant may be approved by the Board but not communicated to

all employees until some time later FASB Staff Position FAS 123(R)-2 allows Board approval to be used

as grant date if (a) it is a unilateral grant and (b) the key T&Cs are communicated within a short period of time


50

Measurement Issues

Reload Features

Question

How are reload grants handled?

Answer

Reload features are not considered in determining fair value Each reload grant is treated as a new award The existence of a reload feature will impact the assumptions used to

value the original awards Use of reloads has decreased dramatically


51

Measurement Issues

Clawback Features

Question

How are clawback features handled?

Answer

Clawback features require employees to return awards under certain conditions, such as non-compete arrangements

Clawback features are not considered in determining fair value The effect of clawbacks are accounted for if and when they occur Income is recognized in an amount equal to the lesser of the original

compensation expense and the fair value of the consideration received


52

Measurement Issues

Post Termination

Question

Does accounting change after an employee terminates?

Answer

FAS 123R would require companies to value awards under different accounting standards after termination

Only applies to awards that remain outstanding for a significant period after termination – at least longer than 90 days

Such awards would be treated as derivative securities and subject to mark-to-market accounting

FASB Staff Position FAS 123(R)-1 deferred this requirement unless the awards are modified at termination


53

Measurement Issues

Employee Stock Purchase Plans

Question

What ESPP provisions create expense?

Answer

Discount – discounts in excess of 5% safe harbor Lookback – purchase prices that are based on the lower of begin and

end prices Modifications – price resetting or variable withholding features FASB Technical Bulletin 97-1 addresses the accounting


54

Measurement Issues

Market Performance Conditions

Question

What are market conditions and how are they treated?

Answer

They are vesting measures based on stock price metrics Includes stock price and total shareholder return measures May be comparative against other companies or indices Must be factored into the fair value determination There is no true-up if performance is above or below fair value

calculation Liability awards are revalued each period


55

Measurement Issues

Non-Market Performance Conditions

Question

What are non-market performance conditions?

Answer

They are vesting measures based on performance metrics that are not stock price related

Examples could be cash flow or earnings per share measures May be comparative against other companies or indices Not included in the fair value determination Expense is trued-up to actual performance


56

Measurement Issues

Service, Market and Performance Conditions

Example

Restricted stock grant at $10 stock price with 1 year vesting

Service Market Performance

Condition Continued service only

TSR exceeds peer group

Revenues increase 10%

Grant Date FV $10 $7 $10

Expense - Condition Met

$10 $7 $10

Expense - Condition Not Met

n/a $7 $0

Expense – Quit before 1 year

$0 $0 $0


57

Measurement Issues

Modifications

Question

What happens when the terms of an award are modified?

Answer

Modification could include changes to price, vesting, term, etc. The value of the award should be measured before and after the

modification The incremental value of the modification is recognized as an

additional expense The original expense continues to be recognized as well


58

Measurement Issues

Modifications

Example

10 options granted at $50 Repriced to $40 one year later Vesting on original grant is 100% at the end of two years Vesting schedule not changed upon repricing

Original Fair Value $20

FV of Original Grant at end of Yr. 1 $12

FV of Repriced Grant at end of Yr. 1 $15 (increase in FV of $3)

Year 1 Expense $100 (= 10 x $20/2)

Year 2 Expense $130 (= 10 x ($20+$3) - $100)


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Measurement Issues

Modifications

Example

10 options granted with four year cliff vesting and $20 fair value All employees are laid-off one year later when fair value is $25 Company accelerates the vesting of all options

FV of Original Grant $20

FV of Original Grant at end of Yr. 1 $0 (employees would not vest)

FV of Modified Grant at end of Yr. 1 $25

Total Expense $250 (= 10 x $25)


60

Attribution Issues

Expense Recognition

Question

Over what period is expense recognized for equity awards?

Answer

Expense is recognized over the requisite service period, which is generally the vesting period

Market conditions that accelerate vesting must be considered and requisite service period is the most likely vesting period

If award vests in tranches, expense can be recognized individually by tranche (which frontloads the expense) or in total on a straight-line basis over the full vesting period

Tranche specific required for market & performance conditions


61

Attribution Issues

Forfeitures

Question

How are forfeitures handled?

Answer

Expense is recognized based on shares granted minus assumed forfeitures (non-vested cancellations)

Over the vesting period, the expense is reconciled to the number of actual forfeitures experienced

Companies may monitor experience versus assumed and establish a variance threshold to determine when to true-up

Alternatively, companies may true-up each period to reflect the current period’s experience versus assumed


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Accounting Rules: Cost Measurement

Fair Value of Instrument x Number of Instruments Granted x Probability of Vesting

Requisite Service Period (years)

Measurement of Compensation Costs

Attribution Issues

Annual Cost =


63

Attribution Issues

Expense Recognition

Example

100 options granted with four year graded vesting Fair value of $20 per option 10% forfeiture assumption

By Tranche By Award

Year 1 Expense $938 $450




Total Expense $1,800 $1,800


64

Attribution Issues

Accelerated Vesting Provisions

Question

What if vesting is accelerated upon retirement?

Answer

Expense should be recognized over the period to retirement eligibility, which may be immediate, if earlier than stated vesting

Stated vesting term is considered non-substantive If pre-FAS 123R awards were not treated this way, then prior practice

should be maintained for these awards Clawback provisions are generally not sufficient to override a

retirement provision

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Taxation of Equity Awards:

1. Non-Qualified Stock Option (NQSO)

2. Restricted Stock (RS)/Restricted Stock Unit (RSU) Awards

3. Special Tax Considerations for Equity Compensation

66

Lifecycle of an NQSO or SAR

67

The important dates in the lifecycle of an appreciation award are:

– Date of Grant

– Date of Vesting

– Date of Exercise

– Date of Disposition of Shares Acquired

Lifecycle of an NQSO/SAR

68


• Treatment on Date of Grant

– Employee: No income recognition

– Employer: No tax deduction

• Treatment on Date of Vesting

– Employee: No income recognition

– Employer: No tax deduction

NOTE: Assumes options cannot be exercised for restricted stock (West Coast options)

69


• Income Tax Treatment on Date of Exercise

– Employee: Ordinary income based on spread between exercise price and FMV at date of exercise

– Employer: Tax deduction equal to employee’s ordinary income

• Withholding, Reporting and Deposit Tax Obligation

– Federal, state, local (if any), and FICA/Medicare withholding at exercise (T+3 for options).

– Deposit taxes at normal cycle unless > $100,000 total federal tax liability – then next day deposit.

– Report on Form W-2 for employees and former employees. Form 1099 for outside directors. Special coding in W-2 Box 12 Code V for NQSOs.

70


• Treatment On Sale of Shares Acquired

– Employee: Capital gain or loss equal to the Sale Price less Exercise date FMV

– Employer: None

71

Lifecycle of an RS/RSU Lifecycle of an RS/RSU AwardAward

72

The important dates in the lifecycle of an The important dates in the lifecycle of an RS/RSU Award are:RS/RSU Award are:

– Date of GrantDate of Grant

– Date of VestingDate of Vesting

– Date of Disposition of Shares AcquiredDate of Disposition of Shares Acquired

Lifecycle of a RS/RSU Award

73


• Treatment on Date of Grant*

– Employee: No taxable income if stock is not transferable and subject to a substantial risk of forfeiture (i.e. subject to vesting)

– Employer: No deduction unless stock is transferable and not subject to a substantial risk of forfeiture

* Assuming no 83(b) elections are made.

74


• Treatment on Date of Vesting*

– Employee: Ordinary income equal to vest-date FMV less cost to employee at the date of grant (if any)

– Dividends paid prior to vesting considered ordinary income and subject to withholding and reported on Form W-2

– Employer: Deduction equal to ordinary income recognized by employee


75


• Treatment on Date of Vesting* - Withholding, Reporting and Deposit Tax Obligation

– Federal, state, local (if any), and FICA/Medicare withholding at vesting

– Deposit taxes at normal cycle unless > $100,000 total federal tax liability – then next day deposit – likely with RS or RSU grants

– Report on Form W-2 for employees and former employees. Form 1099 for outside directors


76


• Treatment on Date of Disposition*

– Employee: Capital gain or loss equal to Sale Price less FMV at vesting date

– Employer: No additional deduction


77

Special Tax Considerations/Issues

for Equity Compensation

78

409A: New tax provisions that governs nonqualified deferred compensation, which includes certain equity compensation awards.

– NQSOs or SARs – either they comply with 409A or they don’t meet certain requirements

– RSUs that do not meet the short-term deferral rules

– Excluded from 409A:

• Incentive Stock Options

• Restricted Stock

Special Tax Considerations

79

Global Equity Tax Considerations: Unique country characteristics can impact the taxation, withholding and reporting, and corporate deductibility of equity awards to employees in foreign jurisdictions.

– Generally, not deductible in the US

– May not be deductible in the foreign country unless certain criteria such as chargeback arrangements are in place

– Tracking employee mobility can be difficult – issues around withholding and reporting obligations

– Increased foreign enforcement


80

Timing of Deduction: Generally, property transferred for the performance of services which is subject to vesting is deductible in the year in which or within which the participants tax year ends.

– Exceptions for stock options that deliver vested stock at exercise

– Problematic for fiscal year companies

– Method of Accounting issues – risk of FIN 48 disclosure


81

Section 162(m): Generally, equity awards have to be considered for purposes of Section 162(m) $1M cap deduction disallowance unless they meet certain criteria.

– Stock Options are generally exempt if not at a discounted exercise price; plan states maximum number of awards for any one individual in any particular period; and grants are made by a compensation committee of independent outside directors.

– Restricted stock/restricted stock units – generally subject to 162(m) unless they meet more onerous performance criteria under 162(m).

Section 280G: Generally, equity awards often vest on a change in control and thus may be subject to lost deductions under Section 280G.

– Companies may have difficulty tracking the lost deductions on awards that are exercised in the years following the transaction.



82

Tax Issues

Deferred Tax Asset

Question

What are book tax implications at grant?

Answer

Deferred tax assets (DTA) are created for awards that normally result in a tax deduction

DTA is built up as the award’s expense is recognized over the vesting period

DTA is not adjusted for stock price changes DTA is eliminated when the award is settled and the deduction is

recognized


83

Tax Issues

Deferred Tax Asset

Example

Option granted on 1/1/07 at $20 stock price with 2 year vesting Grant date fair value using Black-Scholes is $10 Stock price on 12/31/07 is $30 and on 12/31/08 is $40 Tax rate is 40%

Expense DTA GainExpected Deduction

2006 $5 $2 $10 $4

2007 $5 $2 $20 $8

Total $10 $4 $20 $8


84

Tax Issues

Tax True-ups

Question

What are book tax implications at settlement?

Answer

Actual tax deduction will be higher or lower than DTA Tax benefits related to excess deductions will be reflected in Additional

Paid in Capital (APIC) Tax benefits related to shortfall deductions will create additional

expense unless APIC exists that can be offset Need to carry forward amounts if operating at a loss Tax qualified awards impact APIC upon disqualification


85

Tax Issues

Tax True-ups

Example

Option granted at $30 stock price and with $15 fair value Tax rate is 40% and DTA is $6

Price at Exercise $35 $50

Deduction $5 $20

Tax Benefit $2 $8

APIC Credit - $2

Additional Expense (assume no APIC)

$4 -


86

Tax Issues

Tax Transition

Question

What were book tax implications at transition?

Answer

Companies need to determine if APIC balance would have existed if FAS 123 rules had always been followed

Can be used to offset any future shortfall deductions Need to include effects from acquisitions and divestitures Need to consider potential differences in timing and amount of

deductions in various countries / subsidiaries Consider if chargebacks to foreign locations were in place


87

Tax Issues

Tax Transition

Example

Assume first exercises occurred in 2000

Excess Shortfall Opening APIC

2000 $100 $60 $40

2001 $120 $100 $60

2002 $80 $130 $10

2003 $0 $70 $0

2004 $50 $80 $0

2005 $100 $30 $70


88

Tax Issues

Tax Transition

Question

Is there an alternative calculation of the opening APIC pool?

Answer

FASB Staff Position FAS 123(R)-3 created an alternate method Opening APIC balance is (a) all additions to APIC since original FAS

123 minus (b) expense under FAS 123 times the company’s blended statutory tax rate

Need to exclude tax qualified and partially vested awards Tax benefits for fully vested awards will increase the pool Not fully vested awards will be treated under FAS 123R rules


89

Tax Issues

Real APIC Account

Question

How is a company’s real APIC account maintained?

Answer

Previously, tax benefits for stock options were entirely reflected in APIC (assuming no expense under APB 25)

It will now be necessary to determine the amount of expense recognized for each option that is exercised

Zero expense for options fully vested at transition and fair value expense for options granted after the transition

Unvested options at transition will be partially expensed


90

Tax Issues

Real APIC Account

Example

100 options granted on January 1, 2004 with 4 year vesting Fair value of $10 Transition to FAS 123R on January 1, 2006 Options exercised on January 1, 2009 with gain of $12

Memo APIC Real APIC

Deduction $1,200 $1,200

Expense $1,000 $500

Excess to APIC $200 $700


91

Other Issues

Option Disclosures

Question

What are required disclosures for stock options?

Answer

Plan description Number granted, exercised, forfeited, expired and outstanding Assumptions, model and weighted average fair value Intrinsic value of options exercised Number, exercise price, intrinsic value and remaining term of options

outstanding and exercisable Source of shares used upon exercise


92

Other Issues

Share Disclosures

Question

What are required disclosures for restricted shares?

Answer

Plan description Number granted, vested, forfeited, outstanding non-vested Weighted average fair value Fair value of shares vested Intrinsic value of shares paid Total remaining expense for non-vested awards and average period

over which it will be recognized


93

Other Issues

Earnings per Share

Question

How does restricted stock impact EPS?

Answer

Unvested RS are excluded from the denominator of basic EPS They are included for dilutive EPS if vesting is service based or the

market/performance condition has already been satisfied Proceeds under the treasury stock method include unrecognized

compensation expense and any increases or decreases to APIC due to tax effects


94

Other Issues

Earnings per Share

Question

How do stock options impact EPS?

Answer

Options are excluded from the denominator of basic EPS Options are included for dilutive EPS if vesting is service based or the

market/performance condition has already been satisfied Underwater options are excluded Proceeds under the treasury stock method include unrecognized

compensation expense, any increases or decreases to APIC due to tax effects and cash from exercise

More options will be anti-dilutive (and therefore excluded) under FAS 123R than were under APB 25


95

Other Issues

Non-public Companies

Question

How are non-public companies treated under FAS 123R?

Answer

Options may be valued using intrinsic value, fair value, or calculated value

Intrinsic value is used on a mark-to-market basis until settlement Fair value is the same treatment as for public companies Calculated value substitutes an index volatility in the pricing model for

company specific volatility


96

Questions?

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