Stock-based Compensation

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Stock-based Compensation
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Instructor

• Brad Owen - Partner, KPMG LLP
• CA - 1995 CPA (Illinois) - 1999
• Specialize in US GAAP and SEC reporting
• Two-year secondment to Department of Professional
  Practice in New York (10/03)
• Review US GAAP reconciliations for a number of
  public companies in Canada
• Clients included Siemens AG, Amtelecom Income
  Fund, Century II Holdings, CPI Plastics Group
  Inc., Stuart Energy Systems Corporation

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Agenda

• What is it?
• Why do we care?
• Basic accounting issues
• Accounting models
• G41 Proposal
• FASB
• CICA (2002 and 2004)
• IASB (November 2002)
• Recent Standard Setter Developments
• Investors concerns

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What is Stock-based Compensation

• Consideration given 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 (IPOs)

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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

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Why Do We Care?

• 47 make annual option grants
• Growth in option-based awards expected to
  continue
• Canadian public companies must use fair value
  method after 1/1/04
• Many companies in the US are responding to
  pressures and are voluntarily adopting the fair
  value method

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Value of New OptionsUS Data
Based on 144 large SP 500 firms
Source US Federal Reserve Board
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Income Statement Impact
(1) US GAAP
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Goals of PlansR3

• Retention
• Medium to long-term plans
• There are certain tax benefits
• Rewarding performance
• Qualitative goals
• Quantitative goals
• Recruiting in New World economy
• Upside potential was significant and avoided the
  use of cash resources to companies

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Effectiveness of Plans

• Time alone is not a performance enhancer
• Employees typically dont hold shares
• Roth/Nortel
• Drives behaviors that focus on short-term
  appreciation in stock price
• Pump and dump (Enron allegation)

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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
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Basic Accounting Issues

• How to measure it?
• Initially
• Subsequently
• When does it get recognized, if at all?
• How to present it?

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Measurement Issues

• Measurement amount
• Fair value
• Intrinsic value
• No value/historical cost (Settlement
  accounting)
• Measurement dates
• Grant date
• Service period
• Vesting date
• Exercise date

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Measurement AmountStock 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

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To Measure or Not to Measure

• Options have value, even when issued out of or at
  the money
• Inability to transfer doesnt negate value
• Theyre not free to employee or the entity
• Have value even if not exercised
• Measurement difficulties
• Cash paid for employee services is not ignored
• Why should medium of exchange matter

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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 leads to financial
  engineering in US
• APB 25 no compensation cost recognized at all
• Inconsistent with the goals of the plans

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Option Pricing Models

• Black-Scholes
• Binomial
• Example
• Share and exercise prices 10
• Expected life of option 5 years
• Expected volatility 60
• Risk-free rate 3
• Fair value 5.35

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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

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Measurement ProblemsOption Pricing Models

• Gaming through assumption manipulation
• Reverse engineer FV
• Even with the simple plans
• Difficult to estimate volatility projected
  dividend yield expected life as history is not
  always necessarily a good indicator of the future

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Measurement ProblemsOption Pricing Models

• Forfeiture provisions
• Need to estimate and adjust for probability
• 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

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US Reaction to Proposed FV Model (Mid 1990s)

• 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

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Measurement Dates

• Grant date
• Service date
• Vesting date
• Exercise date

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Grant Date

• Date employer and employee come to mutual
  understanding of the terms
• Cant occur prior to start date
• Cant occur prior to shareholder approval, if
  required or requested
• Subsequent changes in value ignored
• Earliest measurement datecheapest cost if
  share prices rising

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Service Date

• Measure as recipient performs 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

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Vesting Date

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

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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

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Example

• Assume 750 options are granted
• 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
• Vest over 3 years
• Term 10 years FV and QMP at end of term 20 and
  35, respectively

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Compensation Cost

• Grant date
• 2,250 3750 options if FV used
• Nil if intrinsic value is used
• Service date
• 3,750 if FV used
• (4250)(5250)(6250)
• 1,500 if intrinsic value used
• ((16-15)250)((17-15)250)((18-15)250)

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Compensation Cost

• Vesting date
• 4,500 6750 options if FV used
• 2,250 if intrinsic value is used
• (18-15)750
• Exercise date
• 15,000 if FV used
• 20750
• No time value remains when exercised at expiry
  date
• 15,000 if intrinsic value used
• (35-15)750

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Comparison
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Authoritative Bodies

• IASBInternational Accounting Standards Board
• Principle-based guidance
• FASBUS Financial Accounting Standards Board
• Rule-based guidance
• CICA
• Principle-based guidance

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IASB Model (2000)

• G41 paper
• Fair value measurement model
• Recognition at the vesting date
• Variable accounting in interim periods
• The type of recipient is irrelevant

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Current FASB Model

• Employee plans
• Fair value at grant date (FAS 123) or
• Intrinsic value at measurement date (APB 25)
• Variable plan accounting bad result
• Fixed plan accounting good result
• Non-employee
• Fair value
• Performance completion date
• Under reconsideration by EITF

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Current FASB Model

• APB 25 (1972)
• Numerous practice interpretations
• SFAS 123 (1995)
• FIN 44 (2000)
• Repairs and maintenance project
• ? 25 EITF issues
• FASB 148 (2003)
• Transitional options for Companies
• Improved disclosures interim reporting
• Exposure Draft seeking harmonization with ED2 of
  the IASB new standard not likely expected until
  mid-2004

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FASB Exposure Draft

• Expected this week (2/23)
• Proposal is for a fair value model for public
  companies policy choice between fair value and
  intrinsic value variable for private companies
• Eliminate minimum value method
• Fair value model preferred model is the
  Binomial Lattice Model

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CICA Model Section 3870 (2002)

• 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
• Be careful when reading the standard
• Written in a context that is inconsistent with
  the terminology used in US literature
• Non-exempt and exempt distinction comes from the
  transitional provisions

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CICA Model Section 3870 (2002)

• Disclosure for exempt awards
• Pro forma net income and EPS
• Effective January 1, 2002
• Certain awards grandfathered
• Certain exempt awards
• Non-employee awards granted prior to the adoption
  date

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Section 3870 (2004)

• Full fair value model approved in 10/03
• Effective 1/1/04 for public 1/1/05 for others
• Will be readdressed if IASB, FASB standards are
  different
• Same transitional provisions as FAS 148
• Retroactive (with or without restatement)
• Prospective for awards not previously accounted
  for under fair value as long as adoption is
  before 1/1/04
• Also allows for harmonization for those who also
  report under US GAAP

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IASB Exposure Draft (11/02)

• Fair value at the grant date
• SARs and other instruments settleable in cash
  and other assets are measured at fair value not
  intrinsic value
• Difference with existing Canadian and US GAAP

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IASB Exposure Draft (11/02)

• Other significant US GAAP and Canadian GAAP
  differences
• Non-employee awards grant date
• No exceptions for non-compensatory plans
• Treatment of forfeitures up-front versus as
  they happen
• Settlements are not impacted immediately
• FASB and CICA are monitoring deliberations
  (stated view is to harmonize)

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Plans to Consider

• Plain vanilla stock option
• Time vesting
• Performance vesting
• SARs
• Non-employee arrangements

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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

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G41 Model (7/00)Fair ValueVesting Date
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US Model (APB 25)Intrinsic ValueMeasurement
Date Fixed Plan
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US Model (APB 25)Intrinsic ValueMeasurement
Date Variable Plan
Assumes 5year performance condition
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US Model (FAS 123)FV ValueGrant Date Equity
Instrument Award
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CICA ModelFair ValueGrant Date
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CICA ModelOpt Out Option
To recognize receipt of cash upon exercise of
stock option by employee Opt out is not
available under new Section 3870
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IASB Model (11/02)
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SummaryPlain Vanilla Option

• G41 (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
• IASB (FV both plans) 200

No longer available under new Section 3870
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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

These are the same attributes as the Option
example
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G41 Model (7/00)Fair ValueVesting Date
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US Model (APB 25)Intrinsic ValueMeasurement
Date Variable Plan
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US Model (FAS 123) FV (Intrinsic Value)
Liability Award
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CICA Model FV (Intrinsic Value) Liability Award
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IASB Model (11/02)Fair Value
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SummarySARs

• G41 1,400
• FASB 1,400
• CICA 1,400
• IASB 1,400 (but note that the recognition
  pattern is different)
• Expected FASB exposure draft will lead to the
  same answer as IASB

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CICA vs. FASB
Not previously discussed No longer
available under new Section 3870
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Other Issues

• Allocation period
• Whose an employee?
• Forfeitures
• Expiry of options
• Modifications--repricing
• Non-compensatory plans

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Recognition of Compensation Cost

• If vesting over the vesting period
• No basis to argue for past services
• Graded vesting vs. cliff vesting
• Choice depending on assumptions about expected
  life
• Recognition given to forfeitures
• Estimate or actual forfeitures
• Expire unexercised ? forfeiture
• Capitalize or expense cost

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Repricing

• IASB re-measurement
• FASB APB 25 re-measurement and variable
  accounting until expire, exercise or forfeited
• 6 month look-back/look-forward
• FASB SFAS 123 re-measurement
• CICA depends
• 3870 Opt out no accounting (again not available
  after effective dates in new 3870)
• 3870 re-measurement
• No US/CAD GAAP difference 3870 SFAS 123

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Non-Employee Awards

• FASB/CICA fair value at measurement date
• Earliest of
• (1) performance commitment date,
• (2) performance completion date, or
• (3) grant date if fully vested non-forfeitable at
  that date
• G41 fair value at the vesting date
• IASB fair value at the grant date

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Who is an Employee

• Under law
• Consistently represented as such
• Directors for director services
• Leased employees
• Microsoft phenomenon
• Need to participate in benefits

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Measurement Date

• Probable supplier will perform
• Sufficiently large disincentive for
  nonperformance
• Excludes forfeiture of equity instruments or
  risk of being sued
• Would continue to perform even though grant
  worthless
• Unlikely anyone would agree to such a penalty
• Matter of judgment
• Result measure at performance completion date
• Estimate cost of goods/service in interim
  periods variable accounting

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Non-Employee Award

• 1,000 options for consulting services
• Performance period 1 year
• FVs at EOQ 10, 8, 14, 20
• Assume no forfeitures

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Cost of Consulting Services
if fully vested non-forfeitable
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Investors Concerns

• Information usefulness
• Who wants to be an optionnaire???
• Dilution/overhang
• Need for shareholder approval
• Circumvent by repurchase shares in market
• Repricing
• non-employee shareholders lose when price falls
• 6 month ruleanti-motivational
• want share price to fall in the interim

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Nightmare on Dilution Street growth Jan.,
1998, through Oct., 2001
Globe and Mail
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Financial Engineering

• Intrinsic value method
• Zero intrinsic value plans
• No performance conditions other than time vesting
• Non-employee plans
• Fully vested non-forfeitable
• Economic reality???

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Questions?