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Greg Callow Matt Faulkner Dana Gies Mary Mumcuoglu Marcel Nugent Tracey Weiler

Stock Options

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Greg Callow Matt Faulkner Dana Gies Mary Mumcuoglu Marcel Nugent Tracey Weiler

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    1. Greg Callow Matt Faulkner Dana Gies Mary Mumcuoglu Marcel Nugent Tracey Weiler

    2. Stock Options & Management Compensation Greg Callow Matt Faulkner Dana Gies Mary Mumcuoglu Marcel Nugent Tracey Weiler

    3. Agenda Learning Objectives General Overview Controversy Accounting Treatment Lessons Learned Questions

    4. Learning Objectives Gain understanding of stock options and management compensation Recognize the differences between past and current accounting treatment of stock options Become familiar with stock option implications as they relate to employee and employer Also the Accounting Differences: Canada, USA, InternationalAlso the Accounting Differences: Canada, USA, International

    5. Management Compensation Purpose: motivate employees to high levels of performance, help retain executives and allow for recruitment of new talent, base compensation on employee and company performance, maximize the employee’s after-tax benefit and minimize the employee’s after-tax cost, and use performance criteria over which the employee has control.

    6. How many of you have stock options in your company? Generate discussion with class Ask those who have options what specific kinds of options they have. Generate discussion with class Ask those who have options what specific kinds of options they have.

    7. Types of Plans Direct Awards of Stock Compensatory Stock Option Plans (CSOPs) Employee Stock Option Plans (ESOPs) Stock Appreciation Rights Plan (SARs) Performance-Type Plans Incentive Stock Options – ISO Nonqualified Stock Options - NQS Compensation might be tied to some performance measure such as an increase in book value or earnings per share. Direct Awards of Stock - Reciprocal, 2-Way Transaction CSOPs - Compensation to Management for producing revenues ESOPs - All Employees, Usually pay for the options, Capital Transactions, Employee investing in the company Stock Appreciation Rights – awards entitling employees to receive cash, stock, or a combination of cash and stack in an amount equivalent to any excess of the market value of a stated number of shares of the enterprise’s stock over a stated price. Performance – Achievement of a specified performance target Incentive stock options (ISO): Taxed on disposition Nonqualified stock options (NQS): No Special tax consideration Compensation might be tied to some performance measure such as an increase in book value or earnings per share. Direct Awards of Stock - Reciprocal, 2-Way Transaction CSOPs - Compensation to Management for producing revenues ESOPs - All Employees, Usually pay for the options, Capital Transactions, Employee investing in the company Stock Appreciation Rights – awards entitling employees to receive cash, stock, or a combination of cash and stack in an amount equivalent to any excess of the market value of a stated number of shares of the enterprise’s stock over a stated price. Performance – Achievement of a specified performance target Incentive stock options (ISO): Taxed on disposition Nonqualified stock options (NQS): No Special tax consideration

    8. Stock Options Defined …securities issued by a company that carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price… The strike price is typically set near the market price of the stock on the day the option is granted Employees must typically wait a specified vesting period before being allowed to exercise the option

    9. Stock Option Motivations The idea behind stock options: To motivate employees…increase performance To offer uncapped potential gain through increased stock price To allow companies to retain talent in the early years To foster a culture of employee ownership To align incentives between the employees and shareholders of a company These are the reasons why so many employees and employers like stock options.These are the reasons why so many employees and employers like stock options.

    10. Shareholders vs. Managers Long term growth Investment growth Seek what is in the best interests of the company Bonus based on short term results such as earnings growth Seek what is in the best interests of themselves For example, management may postpone R&D or capital expenditures that are required for long term competitive survival of the company. For example, management may postpone R&D or capital expenditures that are required for long term competitive survival of the company.

    11. In Practice Closely-held companies often issue stock options IPO driven Public companies Some industries, it has become standard practice such as in high-tech Closely-held companies often issue stock options- intention is to sell or to go public In Canada, from 1997 to 2002 use of stock options more than doubled (25 percent to 59 percent) In the U.S. CEO’s are now paid 8 times as much per dollar of profit as they were in 80s Is it possible that CEO’s are 8 times smarter than they were two decades ago? Past 2 years, CEOs have enjoyed an avg. 57.3% increase in pay, with the avg. 7.6% gain in wages and benefits or ordinary workers. Closely-held companies often issue stock options- intention is to sell or to go public In Canada, from 1997 to 2002 use of stock options more than doubled (25 percent to 59 percent) In the U.S. CEO’s are now paid 8 times as much per dollar of profit as they were in 80s Is it possible that CEO’s are 8 times smarter than they were two decades ago? Past 2 years, CEOs have enjoyed an avg. 57.3% increase in pay, with the avg. 7.6% gain in wages and benefits or ordinary workers.

    12. Can anyone think of the main reasons for what was good in theory, but ended up being bad in practice? Get a discussion going on what the class thinks Prompt them to think about the motivations behind offering stock options for both the employee and the employer Get a discussion going on what the class thinks Prompt them to think about the motivations behind offering stock options for both the employee and the employer

    13. The Good vs. The Bad Focus remained on quarterly performance rather than on long term Were allowed to sell stock after exercising options What do you think about amending option plans to require employees to hold their shares for a year or two after exercising them? Tax laws allowed managements to manage earnings by increasing the use of options instead of cash wages If a company wished to maintain its EPS growth rate and they thought it might be difficult to do so, they could implement new option programs thus reducing growth in cash wages. 1. Would allow for a longer-term view 1. Would allow for a longer-term view

    14. The Ugly Option abuse has 3 major adverse impacts: Oversized rewards given by servile boards to ineffective executives In earlier years, BODs allowed executives to exercise and sell stock with less restrictions than those placed on lower-level employees Repricing options rewards underperformers at the expense of the common shareholder Repricing “out of the money” options in order to keep employees from leaving Who will reprice the shareholders’ shares?

    15. The Ugly cont… 3. Increases dilution risk as more and more options are issued EPS dilution from an increase in shares outstanding Earnings reduced by increased interest expense Management dilution – management spending more time maximizing option payout and financing stock repurchase programs than running the business

    16. The Ugly cont…

    17. Accounting Treatment To Expense or Disclose? Should employers expense stock option costs in calculating net income? Employers already disclose the cost in the notes to the financial statements and must show the potential impact on earnings. Expensing options significantly reduces EPS Companies can deduct for tax purposes GAAP doesn’t require expense of options -Should employers expense stock option costs in calculating net income Opponents believe there is no fair or standardized way of valuing these costs -Stock options have perplexed accountants and regulators for the last decade. What’s the debate about? In the past, companies had the choice to either expense or disclose stock option expense. If companies choose to expense their stock options, it could negatively affect their bottom line, thus decreasing earnings per share which most analysts and investors look at when purchasing stocks. We noted that it mostly impacts growing companies, usually high-tech firms, because, as you’ve read in our reading today, growing companies are usually cash starved and therefore, must compensate their employees in ways other than through salary. Hence, the growth of stock option compensation. -As you can see, it can be quite complex, so why do companies choose to disclose as opposed to expense? Well, for the growing companies, as I mentioned before, it can be the difference between a positive stock price and a negative stock price, since expensing can have such an impact on the net income. -Similarly, according to Standard & Poor’s, expensing options would reduce reported 2004 earnings among the S&P 500 by 7.4% while the effect on many technology firms would be much greater. For example, in an August 2, 2004, press release, Intel reported that its second-quarter 2004 profit would have decreased 17% if it had expensed its stock options-Should employers expense stock option costs in calculating net income Opponents believe there is no fair or standardized way of valuing these costs -Stock options have perplexed accountants and regulators for the last decade. What’s the debate about? In the past, companies had the choice to either expense or disclose stock option expense. If companies choose to expense their stock options, it could negatively affect their bottom line, thus decreasing earnings per share which most analysts and investors look at when purchasing stocks. We noted that it mostly impacts growing companies, usually high-tech firms, because, as you’ve read in our reading today, growing companies are usually cash starved and therefore, must compensate their employees in ways other than through salary. Hence, the growth of stock option compensation. -As you can see, it can be quite complex, so why do companies choose to disclose as opposed to expense? Well, for the growing companies, as I mentioned before, it can be the difference between a positive stock price and a negative stock price, since expensing can have such an impact on the net income. -Similarly, according to Standard & Poor’s, expensing options would reduce reported 2004 earnings among the S&P 500 by 7.4% while the effect on many technology firms would be much greater. For example, in an August 2, 2004, press release, Intel reported that its second-quarter 2004 profit would have decreased 17% if it had expensed its stock options

    18. Accounting Treatment cont… Pre 2002 – no standard under GAAP Jan. 1 2002 - CICA introduced section 3870 (Canadian Standard): Fair value of the stock options is determined and recorded as compensation expense over the vesting period of the option - starting 2002 ASB – accounting standards boardPre 2002 – no standard under GAAP Jan. 1 2002 - CICA introduced section 3870 (Canadian Standard): Fair value of the stock options is determined and recorded as compensation expense over the vesting period of the option - starting 2002 ASB – accounting standards board

    19. Canada Pre 2002 – no standard under GAAP Jan. 1 2002 - CICA introduced section 3870 (Canadian Standard): Fair value of the stock options is determined and recorded as compensation expense over the vesting period of the option - starting 2002 Jan. 1 2004 – mandatory expense for public companies Jan. 1 2005 – mandatory expense for private companies Pre 2002 – no standard under GAAP Jan. 1 2002 - CICA introduced section 3870 (Canadian Standard): Fair value of the stock options is determined and recorded as compensation expense over the vesting period of the option - starting 2002 Pre 2002 – no standard under GAAP Jan. 1 2002 - CICA introduced section 3870 (Canadian Standard): Fair value of the stock options is determined and recorded as compensation expense over the vesting period of the option - starting 2002

    20. Impact to Cott Corp. & Nortel Cott’s NI before option compensation was $6.14 M in ’02 Including the impact of options decreased NI to a loss of $2.36 M, a decrease of ~140% Nortel reported a net loss of $5.631 B in ’02 Including the impact of options increased this loss to $7.13 billion, an impact of nearly 27% or ~$1.5 B

    21. SFAS. No. 123 (US Standard) Pre 1995 – choice was up to the company Then in 1995, the initial proposal surfaced that would require companies to expense the total fair value of options. There was strong opposition. Status quo continued and they had a choice: recognizing on the Income Statement or, disclosing in a footnote Amortize total fair value over vesting period of the stock options (SFAS 123 – Revised 2004) August 1st 2005, required to recognize as an expense on the Income Statement Statement of Financial Accounting Standard (SFAS) Initial proposal This Lead to a very strong opposition, one in the greatest in history FASB. The board eventually moved away from its initial proposal…..and eventually decided on Companies are not obligated to recognize stock option expense in income – They basically gave firms a choice – they can recognize it or have a footnote disclosure And secondly, a company can amortize the total fair value over the vesting period of the stock options However, this Standard was revised in 2004 – Requiring ALL companies to apply the fair value method – resulting in Improve comparability of reported financial information by eliminating these alternative methods. Simplifying US GAAP – requiring all companies use the same method THIS IS EFFECTIVE ….first annual period after December 15, 2005 Statement of Financial Accounting Standard (SFAS) Initial proposal This Lead to a very strong opposition, one in the greatest in history FASB. The board eventually moved away from its initial proposal…..and eventually decided on Companies are not obligated to recognize stock option expense in income – They basically gave firms a choice – they can recognize it or have a footnote disclosure And secondly, a company can amortize the total fair value over the vesting period of the stock options However, this Standard was revised in 2004 – Requiring ALL companies to apply the fair value method – resulting in Improve comparability of reported financial information by eliminating these alternative methods. Simplifying US GAAP – requiring all companies use the same method THIS IS EFFECTIVE ….first annual period after December 15, 2005

    22. IFRS 2 (International Standard) Requires all entities to recognize share based compensation as an expense Fair value method is applied Improves comparability of financial reporting around the world IFRS 2 – International Financial Reporting Standard US and International Standard – very similar which makes the accounting requirements for entities that report both in US and international less burdensome.IFRS 2 – International Financial Reporting Standard US and International Standard – very similar which makes the accounting requirements for entities that report both in US and international less burdensome.

    23. Disclosure Current Regulations include: Separate description of multiple plans where companies have > one stock-based compensation plan Which options-pricing model is used Including underlying assumptions Number and weighted average exercise price of options: Outstanding at beginning and end of the year Granted during the year Exercised, forfeited or expired during the year Exercisable at the end of the year SIMILAR TO ALL COUNTRIES Companies with more than one stock-based compensation plan should provide a description of the plans in their notes to the financial statements. The option pricing model and the assumptions used during the year to estimate the fair value should also be disclosed in the notes. SIMILAR TO ALL COUNTRIES Companies with more than one stock-based compensation plan should provide a description of the plans in their notes to the financial statements. The option pricing model and the assumptions used during the year to estimate the fair value should also be disclosed in the notes.

    24. Do strong arguments remain for or against expensing? Do you all agree that they should be expensed? - William Sahlman in a Harvard Business Review, Dec. ’02 article also points out that expensing of options would solve some accounting inconsistencies and create others: contingency-based compensation, indexed options vs. general options, restricted stock grants Do strong arguments remain for or against expensing? Do you all agree that they should be expensed? - William Sahlman in a Harvard Business Review, Dec. ’02 article also points out that expensing of options would solve some accounting inconsistencies and create others: contingency-based compensation, indexed options vs. general options, restricted stock grants

    25. Accounting Treatment cont… Real Debate centered around value Fair value – option pricing models require many assumptions, all of which vary over time Black-Scholes Model Timing – when the actual expense is incurred When awarded? When exercised? To others, the real debate centered around value: Should employers expense stock option costs in calculating net income Opponents believe there is no fair or standardized way of valuing these costs Option pricing models require many assumptions – all of which vary over time. Accounting standards do not specify which option-pricing model to use – most widely used is the Black-Scholes option-pricing model Timing – if you are given the right to pay $10 for a $12 stock but do not actually gain that value (by exercising the option ) until a later period, when does the co. actually incur the expense? When it gave you the right , or when it had to pay up?To others, the real debate centered around value: Should employers expense stock option costs in calculating net income Opponents believe there is no fair or standardized way of valuing these costs Option pricing models require many assumptions – all of which vary over time. Accounting standards do not specify which option-pricing model to use – most widely used is the Black-Scholes option-pricing model Timing – if you are given the right to pay $10 for a $12 stock but do not actually gain that value (by exercising the option ) until a later period, when does the co. actually incur the expense? When it gave you the right , or when it had to pay up?

    26. Valuation Pre S.3870 Intrinsic approach Record expense as the amount that the market price exceeded the exercise price at its grant date Where market was not > exercise price, companies were not required to record impact Post S. 3870 Fair value, using any method Black-Scholes Binomial S 3870 states: “the total amount of compensation cost recognized for an award of stock-based employee compensation should be based on the number of instruments that eventually vest” (3870.44) and “the compensation cost of a stock-based award to employees should be recognized over the period in which the related employee services are rendered, by a chard to compensation cost if the award is for future performance…If an award is for past services, the related compensation cost should be recognized in the period in which it is granted” (3870.49)S 3870 states: “the total amount of compensation cost recognized for an award of stock-based employee compensation should be based on the number of instruments that eventually vest” (3870.44) and “the compensation cost of a stock-based award to employees should be recognized over the period in which the related employee services are rendered, by a chard to compensation cost if the award is for future performance…If an award is for past services, the related compensation cost should be recognized in the period in which it is granted” (3870.49)

    27. Taxation Benefits from stock options are included in employment income in year in which they are disposed ? favourable to employees Also popular with employers because there is no immediate cash cost ? favourable to employers Benefits from a stock option are generally included in employment income in the year in which they are disposed ? favourable to employees Benefits from a stock option are generally included in employment income in the year in which they are disposed ? favourable to employees

    28. Future direction Eliminate options altogether Direct award of stock would eliminate the value debate Direct award of cash To reduce the dilutive effect, implement stock repurchase programs Get a discussion going….ask the class what they think?Get a discussion going….ask the class what they think?

    29. Weaknesses Still not focus employees on long-term financial goals Little corporate governance Outside the scope of management controls  Not immediate benefits

    30. Strengths Motivates and retains employees Cash is infused into companies when employees exercise their options Great upside (gain) benefit potential Innovative technology Is protected by US and several EU member patents First to market, with existing clinical studies and published research articles Associated with Sunnybrook & Women’s College Health Sciences Centre hospital Innovative technology Is protected by US and several EU member patents First to market, with existing clinical studies and published research articles Associated with Sunnybrook & Women’s College Health Sciences Centre hospital

    31. It’s time to play Family Feud…

    32. Lessons Learned No longer reserved for executive suite Still popular, even after the dot-com crash Can be expensive to exercise Two common types of plans Nonqualified stock options Qualified, or “incentive” stock options (ISOs) It’s usually smart to hold options as long as you can There may be compelling reasons to exercise early Stock options aren’t your only option for compensation Nonqualified are transferable to children and charity ISOs qualify for special tax treatment, gains may be taxed at capital gains rates instead of higher, ordinary income ratesNonqualified are transferable to children and charity ISOs qualify for special tax treatment, gains may be taxed at capital gains rates instead of higher, ordinary income rates

    33. Questions?

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