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Stock-Based Compensation

Employee compensation made in the form of stock awards or tied to changes in market value of the companys stock Stock-based compensation plans

Noncompensatory employee stock purchase plans

No special accounting treatment

Compensatory

Compensatory Plans
Stock appreciation rights plans Performance-type plans Stock option plans

Incentive plans Nonqualified plans

Stock Appreciation Rights

Executives are paid bonus in stock or cash based on increase in market price of stock Total compensation is measured when rights are exercised; estimated in interim reporting periods

Performance-Type Plans

Number of shares of stock awarded to executive is tied to performance criteria, e.g. earnings growth Total Compensation is the market value of shares issued (measured when stock is awarded); estimated in interim reporting periods

Stock Option Plans

Executives are granted options to purchase company stock at a preestablished price Options are earned during service period between date of grant and initial exercise date Value of options depends on increases in market price of stock Accounting issue has been whether and how to measure cost to company of granting stock options

Measuring the Value of Stock Options

Intrinsic value = excess of market price of stock over exercise price Time value = speculative value of option based on characteristics of stock and duration of the option Fair value = intrinsic value + time value

Determined in market if option is traded May be estimated using an option pricing model

Stock Option Plans Incentive vs. Nonqualified Plans

Distinction is based on tax law Incentive plan provides greater tax benefits to executives To qualify as incentive stock option, the exercise price cannot be less than market price at date of grant; that is

Incentive stock options have an intrinsic value of zero when granted

Accounting for Stock Option Plans Chronology


APBO No. 25 - Intrinsic Value (IV) method

Superseded by SFAS 123 (revised 2004)

SFAS No. 123 - Original Stock-Based Compensation

Allowed two methods of accounting


Intrinsic value method Fair value method

Additional disclosures required if IV method used SFAS 123 encouraged use of Fair Value method

SFAS No. 123 (revised 2004) Share-Based Payment

Requires use of fair value method (with some modifications from SFAS No. 123 (original))

Intrinsic Value Method APBO 25

Total compensation cost is measured as the intrinsic value of the option at the date granted

measured once at the date the options are granted Total compensation cost is allocated (recognized) over the service period on a straight-line basis

PROBLEM! Total compensation cost for incentive stock options will be ZERO

Fair Value Method SFAS No. 123 (Original)

Total compensation cost is measured using an option pricing model to estimate fair value of options

Total compensation cost is measured once at the date the options are granted Total compensation cost is allocated (recognized) over the service period on a straight-line basis Mathematical models developed by finance researchers Models estimate market value of an option based on factors including Duration of option and Volatility of stock

Option pricing models


Fair Value Method SFAS No. 123 (revised 2004)


Issued in December 2004 Eliminates intrinsic value method as acceptable method of accounting for compensatory stock options; Requires the fair value method Option pricing model may be adjusted for unique characteristics of those instruments Compensation is recognized over the period in which the employee is required to provide services (expected forfeitures are estimated when the options are granted)

SFAS No. 123 Disclosures


Description of option plan(s) Number of options and weightedaverage exercise price Description of method (option pricing model) and significant assumptions used to estimate fair value of options

What Next?

The FASB (with the support of the SEC) has now required companies to expense the fair value of equity instruments granted to employees Many companies (and others) still oppose the FASBs position

Legislation??

Additional information?
The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America
By Alex Berenson
Chapter 7 - Options

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