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Stock-based Compensation

Stock-based Compensation. Brad Owen. Senior Manager, KPMG LLP 1 0 years CA - 1995; CPA (Illinois) - 1999 Specialize in US GAAP and SEC reporting Review US GAAP reconciliations for a number of public companies in Canada Clients include Siemens AG, AGI, Stuart Energy. Agenda. What is it?

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Stock-based Compensation

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  1. Stock-based Compensation

  2. Brad Owen • Senior Manager, KPMG LLP • 10 years • CA - 1995; CPA (Illinois) - 1999 • Specialize in US GAAP and SEC reporting • Review US GAAP reconciliations for a number of public companies in Canada • Clients include Siemens AG, AGI, Stuart Energy

  3. Agenda • What is it? • Why do we care? • Basic accounting issues • Accounting models • G+4 (IASB proposal) • FASB • CICA • Investors’ concerns

  4. What is Stock-based Compensation • Consideration in return for goods or services • Employee or non-employee • Consideration can be Options, direct share awards or liabilities indexed to common shares • Excludes shares issued for cash (IPO’s)

  5. Why Do We Care? • Stock-based arrangements are front and centre in the press • ∽ 90 % of TSE 100 companies have at least one equity-based program for directors • 7 of 99 provide only options as remuneration

  6. Why Do We Care? • 47% make annual option grants • Growth in option-based awards expected to continue

  7. Value of New Options—US Data *Based on 144 large S&P 500 firms Source: US Federal Reserve Board

  8. Income Statement Impact (1) US GAAP

  9. Goals of Plans—R3 • Retention • Medium to long-term plans • 3-year performance period avoids tax cost for recipient • Rewarding performance • Qualitative goals • Quantitative goals • Recruiting in New World economy

  10. Effectiveness of Plans • “Time” is not a performance enhancer • Employees typically don’t hold shares • Roth/Nortel • Drives behaviors that focus on short-term appreciation in stock price • Pump and dump (Enron allegation)

  11. Effectiveness of Plans Based on stock owned at the beginning of 2001 CEOs in high ownership group had a medium ownership stake of $30M CEOs in low ownership group had a medium ownership stake of $1.8M (1) Total return to shareholders

  12. Basic Accounting Issues • How to measure it? • Initially • Subsequently • When does it get recognized, if at all? • How to present it?

  13. Measurement Issues • Measurement amount: • Fair value • Intrinsic value • No value/historical cost • Measurement dates: • Grant date • Service period • Vesting date • Exercise date

  14. Measurement Amount—Stock Options • Fair value = IV + Time Value • Willing buyer/willing seller • Quoted market price (QMP) • Estimation models • Intrinsic value (IV) = market price of underlying – exercise price • Can never be negative • Can be zero • Historical cost = 0

  15. To Measure or Not to Measure • Options have value, even when issued out of or at the money • Inability to transfer doesn’t negate value • They’re not free to employee or the entity • Have value even if not exercised • Dot.com phenomena • Measurement difficulties • Cash paid for employee services is not ignored • Why should medium of exchange matter

  16. Which Measurement Basis? • Reciprocal transactions generally are measured at FV • E.g., business combinations consummated with shares not considered a capital transaction • Intrinsic value method lead to financial engineering in US • APB 25: no compensation cost recognized at all

  17. Option Pricing Models • Black-Scholes • Binomial • Example: • Share and exercise prices = $10 • Expected life of option = $5 • Expected volatility = 60% • Risk-free rate = 3% = $1.59

  18. Option Pricing Model Assumptions • Exercise price • higherlower FV • Expected life of option • longerhigher FV • Current price (FV) of underlying stock • higherlower FV • Expected volatility • higherhigher FV • Expected dividend yield • higherlower FV • Risk-free rate during term of option • higherhigher FV

  19. Measurement Problems—Option Pricing Models • Gaming through assumption manipulation • Reverse engineer FV • Even with the simple plans • Difficult to estimate volatility; projected dividend yield • History not necessarily good indicator

  20. Measurement Problems—Option Pricing Models • Delayed vesting • Modify standard binominal model • Forfeiture provisions • Need to estimate and adjust for probability

  21. Measurement Problems—Option Pricing Models • Non-transferability • Employees value stock less than cash • FASB focus on value to entity • Capital structure effects • Issuer to exchange traded options not the entity • Operating income effects

  22. US Reaction to Proposed FV Model • Vociferous lobbying of the FASB • Negative market impact on stock prices • Focus on recognition, not disclosure • Information inefficiency??? • Non-binding Senate resolution opposing FV model • Changed to FV-disclosure option (except non-employee options) • Definition of non-employee broad

  23. Measurement Dates • Grant date • Service date • Vesting date • Exercise date

  24. Grant Date • Date employer and employee come to mutual understanding of the terms • Can’t occur prior to start date • Can’t occur prior to shareholder approval, if required or requested • Subsequent changes in value ignored • Earliest measurement date—”cheapest” cost if share prices rising

  25. Service Date • Measure as perform service: • Theoretically 365 measurement dates in a year of service • Subsequent changes in value ignored for units already recognized • Final measure will be approx. equal average share price in the period

  26. Vesting Date • Date award vests • Interim changes in value considered • Variable accounting • “Expensive” relative to grant or service dates in a rising market

  27. Exercise Date • Date award is exercised • May be years after service rendered to earn award • Changes in interim period considered: • Variable accounting • Post-vesting and post-employment • Most expensive date in rising market

  28. Example • Assume granted 750 options • Exercise price is $15 and QMP is $15 • EOY QMPs: $16; $17; $18 • Fair value is $3 on grant date • EOY FVs: $4; $5; $6 • (not realistic to assume TV constant) • Vest over 3 years • Term 10 years: FV and QMP at end of term $20 and $35, respectively

  29. Compensation Cost • Grant date: • $2,250= $3*750 options if FV used • Nil if intrinsic value is used • Service date: • $3,750 if FV used • ($4*250)+($5*250)+($6*250) • $1,500 if intrinsic value used • (($16-$15)*250)+(($17-$15)*250)+(($18-$15)*250)

  30. Compensation Cost • Vesting date • $4,500 = $6*750 options if FV used • $2,250 if intrinsic value is used • ($18-$15)*750 • Exercise date: • $15,000 if FV used • $20*750 • No time value remains when exercised at expiry date • $15,000 if intrinsic value used • ($35-$15)*750

  31. Comparison

  32. Authoritative Bodies • IASB—International Accounting Standards Board • Principle-based guidance • FASB—US Financial Accounting Standards Board • Rule-based guidance • CICA • Principle-based guidance

  33. IASB Model (Proposed) • G4+1 paper • Fair value measurement model • Vesting date • Variable accounting in interim periods • The type of recipient is irrelevant

  34. FASB Model • Employee plans: • Fair value at grant date(rarely used) or • Intrinsic value at measurement date: • Variable plan accounting: “bad” result • Fixed plan accounting: “good” result • Non-employee: • Fair value • Performance completion date • Under reconsideration by EITF

  35. FASB Model • SFAS 123 (1995) • APB 25 (1972) • Numerous practice interpretations • FIN 44 (2000) • Repairs and maintenance project • ∽ 20 EITF issues

  36. CICA Model Mixed model, depends on award type: • Non-exempt awards: • SARs settleable with equity instruments • FV or intrinsic value • All awards settleable with cash or other assets (includes SARs) • Intrinsic value • Direct awards of stock • Fair value • ALL awards to non-employees • Fair value • Exempt awards: everything else

  37. CICA Model • Disclosure for exempt awards • Pro forma net income and EPS (if required) • Effective January 1, 2002 • Certain awards “grandfathered” • Certain “exempt” awards • Non-employee awards granted prior

  38. Plans to Consider • Plain vanilla stock option • Time vesting • Performance vesting • SARs • Non-employee arrangements

  39. Plain Vanilla Stock Option • Date of grant: Jan. 1, 20X0 • Market price at grant date: $10 • Exercise price: $10 • Fair value at grant date: $2 • Vesting period: 100% at Dec. 31, 20X2 • Expiration date: 5 yrs. from grant • Number of options granted: 100 • EOY market prices: $12, $12, $17, $16, $24 • EOY fair values: $3, $5, $7, $6, $14

  40. IASB Model (Proposed)Fair Value—Vesting Date

  41. FASB ModelIntrinsic Value—Measurement Date: Fixed Plan

  42. FASB ModelIntrinsic Value—Measurement Date: Variable Plan* *assume Yr 5 performance condition

  43. FASB ModelFV Value—Grant Date: Equity Instrument Award

  44. CICA ModelFair Value—Grant Date

  45. CICA ModelOpt Out Option To recognize receipt of cash upon exercise of stock option by employee

  46. Summary—Plain Vanilla Option • IASB (FV – both plans): $700 • FASB (IV - fixed plan): $0 • FASB (IV - variable plan): $1,400 • FASB (FV - both plans): $200 • CICA: (FV – both plans): $200 • CICA (opt out): $0* *not considered a compensation transaction

  47. Stock Appreciation Rights • Date of grant: Jan. 1, 20X0 • Market price at grant date: $10 • Exercise price: $10 • Fair value at grant date: $2 • Vesting period: 100% at Dec. 31, 20X2 • Payout/Expiration date: 5 yrs. from grant • Number of options granted: 100 • EOY market prices: $12, $12, $17, $16, $24 • EOY fair values: $3, $5, $7, $6, $14

  48. IASB Model (Proposed)Fair Value—Vesting Date

  49. FASB ModelIntrinsic Value—Measurement Date: Variable Plan

  50. FASB ModelFV Value—Liability Award

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