Ch. 19 - Share Based Compensation

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There is no entry on

date of grant

Stock Option (definition)

employee has the option to buy : 1) specified number of shares of stock 2) at a specified price 3) during a specified time period

If restricted stock is forfeited,

entries previously made related to that employee would simply be reversed

SARS payable in shares (equity)

estimate fair value of SAR at grant date and accrue compensation expense over service period

Current GAAP requires

fair value accounting for employee stock options

Service period

from the grant date to vesting date

Greater the stock volatility

greater the potential profit -the higher the probability of large increases or decreased in market price

Estimated forfeitures

if experience indicates that a material number of options will be forfeited before they vest, we adjust fair value estimate made on the grant date

Fair value of an option

intrinsic value + time value of money + volatility

The cash settlement of an equity award

is considered the repurchase of an equity instrument

Exercise price is higher

option's value will be lower

Graded vesting

options vest gradually 25% first year, 25% second, 50% third, 25% fourth year -estimate a single fair value for each of the options, using a single weighted-average expected life of the options

Cliff Vesting

options vest on one single date

If it is probable that performance target will be met

our initial estimate of total compensation will not change

Stock Appreciation Rights (SARS)

overcome disadvantage of stock options (employees must come up with enough cash to take advantage of option)

At the vesting date,

paid-in-capital restricted stock is replaced by common stock and paid in capital -excess of par

If these conditions are met,

simply record the sale of new shares

Intrinsic value (An option that permits buy $25 stock for $10)

the benefit is $15 to the holder by exercising the option

Periodic expense and adjustment to liability

the fraction of total compensation earned to date by recipients of SARs - (reduced) by any amounts expensed in prior periods

The longer the time until expiration

the greater the time value

Volatility Value

the possibility that the option holder might profit from market price appreciation of the underlying stock while being exposed to the loss of only the value of the option rather than the full market value of the stock`

Ex) Fair value of option to buy a share at an exercise price of $30 might be measured as $7

the potential loss from a stock failing to appreciate is $7

For example) exercise price is $30, if the present value (discounted at risk free rate) is $24

time value of money is $6

If we estimate two years later that it is not probable that sales will increase by 10%,

we would reverse the 40M expense recognized in 2013, 2014 -no compensation can be recognized

Vesting date

when restrictions are lifted

SAR: Accounting Treatment is based on

whether the employer is obligated to transfer assets, cash to the employee

If we assume it is not probable, then in the third year we say it is probable, we revise our total compensation of 80M

Dr. Compensation Expense [(80M * 3/4)-0] 60M Cr. PIC- stock options 60M 2016 Dr. Compensation expense (80-60) 20M Cr. PIC-stock options 20M

When shares have vested,

Dr. Paid in capital - restricted stock (60M) Cr. Common stock (5M X 1) Cr. Paid in capital - excess (55M)

An employee buys shares under the plan for $850 rather than the current market price of $1,000

The $150 discount is recorded as compensation expense Dr. Cash $850 Dr. Compensation expense $150 Cr. Common Stock (market value) $1,000

The award is considered a liability

if the employee will receive cash or can elect to receive cash

Stock Volatility

is the amount by which a stock's price has fluctuated previously or expected in the future

Compensation associated with restricted stock (non vested stock) is

the market price at grant date any market price changes after the grant date do not affect compensation expense

If the stock pays dividends or is expected to during the life of the option

the time value of money component is lower

The time between the grant date and the first day they can be exercised is

the vesting period (service period)

Employee Share Purchase Plans (requirements)

- all employees can participate - employees have no longer than one month after the price is fixed to decide whether to participate -the discount is no greater than 5% (or reasonable)

Performance-based options

-are not exerciseable until a performance target is met -divisional revenue, EPS, sales growth, ROA -compensation is recorded only when its probable that the performance target will be met, and ultimately whether it is actually met

If these conditions are NOT met, say 15% discount

-considered compensation and should be recorded as an expense

SARS (definition)

-employee awarded share appreciation -Share appreciation = the amount by which the market price on the exercise date > market price at grant date

Market Condition Based Stock Options

-no special accounting treatment -recognize compensation expense regardless of when, if ever, the market condition is met

Employee Share Purchase Plans

-permit all employees to buy shares directly from their company at favorable terms -encourage employee ownership of the company's shares -purchase without brokerage fees and a slight discount

Restricted Stock Award plans

-tied to continued employment -shares are subject to forfeiture by the employee if employment is terminated within some specified number of years from the grant date - employee is not free to sell the shares during the restriction period

Option-Pricing Theory

1) Intrinsic value 2) Time value

Share-Based Compensation Plans

1) Stock award 2) Stock option 3) stock appreciation rights (SARS)

Accounting objective

1) determine fair value of compensation 2) record compensation expense over the periods participants perform services

Option's value will be higher when:

1) time of the option is longer 2) market price of stock is higher 3) dividends are higher 4) risk free rate of return is higher 5) volatility is higher

If a forfeiture of 5% is expected, estimated total compensation would be

95% of total compensation, recompute compensation expense each year based on this

Record compensation expense (each year)

Dr. Compensation expense 15M Cr. Paid in capital- restricted stock 15M

When Unexercised Options Expire

Dr. Paid-in-capital- stock options (remaining balance) Cr. Paid-in-capital- expiration of stock options

For example) exercise price is $30, if the present value (discounted at risk free rate) is $24, discounted present value of dividends were $2

Time value of money is $6-$2= $4

The liability continues to be adjusted

after the service period if the rights haven't been exercised yet

Stock Option compensation is measured

at the fair value of the stock options at the grant date

An option's value is enhanced

by the delay in paying cash for the shares

When Options are exercised

Dr. Cash (exercise price x shares exercised) Dr. Paid in capital - stock options (half of account bal. total compensation) Cr. CS Cr. Paid in capital - excess

The award is considered equity when

the employer can elect to settle in shares of stock rather than cash

SARS payable in cash (liability)

-estimate fair value of SAR and recognize compensation expense over service period -periodically re-estimate the fair value to adjust the liability

Restricted Stock: Universal grants five million of its $1 par common shares to certain key executives at January 1, 2013. The shares are subject to forfeiture if employment is terminated within four years. Shares have a current market price of $12 per share

Grant Date - January 1, 2013 Market price/Fair value $12 Total compensation= 12 X 5M shares = 60M 60/4 = 15M per year

If the share price rises from $35 to $50,

the employee receives $15 cash for each SAR held -usually payable in cash or shares

When the underlying stock pays no dividends, the time value of money component is the difference between

the exercise price (future amount) and its discounted present value

The holder of an option does not have to pay

the exercise price until the option is exercised

If fair value falls below the amount expensed to date

the expense and liability are reduced

The fair value of a SAR =

the fair value of a stock option with the same terms


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