Final Part 2

Under accounting rules in effect before 2006, why might managers and directors view stock options as "free" (or at least "cheap") ways of providing incentives and compensation to employees?

1. Shareholder approval not required, no cash cost, cash inflows at exercise 2. No accounting cost. No cash outlay when the option is exercised, the company (usually) issues a new share to the executive, and receives both the exercise price and (for non-qualified stock options) a tax deduction for the spread between the stock price and the exercise price. These factors make the "perceived cost" of an option much lower than the economic cost.

Would the board need to obtain shareholder approval before making this grant, assuming that the CEO was the only person eligible to receive options? Remember it is July 1999

1. Under listing rules in affect at the time, companies needed shareholder approval for equity plans covering top-level executives, but did not need approval for broad-based plans. 2.NYSE and NASDAQ passed uniform new rules requiring shareholder approval for all equity plans, with no exemption for broad-based plans. The new rules—which also required shareholder approval for option repricings—were approved by the SEC and went into effect in July 2003 Under listing rules in place during the 1990s, companies needed shareholder approval for equity plans covering top-level executives, but did not need approval as long as a sufficient percentage of eligible employees were nonexecutives. Therefore, companies could bypass shareholder votes by granting options to lower-level employees as well as executives. Yes. (Actually, the board would need shareholder approval to have shares authorized to grant, but not approval for any specific grant.)

53b. Describe how the company would "account" for these options under GAAP following FAS 123 (issued in 1995).

100,000×($35) = $3,500,000 amortized over 4 years or $875,000 per year. you multiply 100,000 (options) by black Scholes values 1995, the Financial Accounting Standards Board issued FAS 123, which recommended that companies treat as an expense the "fair market value" of options granted The original 1995 FASB Statement No. 123 claimed that fair value should be based on the expected term as an assumption or input to an option valuation model — typically Black-Scholes — rather than the contractual term input

d) The 1993 limit on deductibility of executive compensation.

1993, President Clinton backtracked on the idea of making all compensation above $1 million unreasonable and therefore non-deductible, suggesting that exemptions would be granted if the company could meet (not yet developed) federal standards proving that the executive improved the firm's productivity. performance-based for the CEO and the four highest-paid people in the firm. Performance-based compensation, as defined under Section 162(m), includes commissions and pay based on the attainment of one or more performance goals, but only (1) the goals are determined by an independent compensation committee consisting of two or more outside directors, and (2) the terms of the contract (including goals) are disclosed to shareholders and approved by shareholders before payment. Stock options generally qualify as performance based, but only if the exercise price is no lower than the market price on the date of grant. Base salaries, restricted stock vesting only with time, and options issued with an exercise price below the grant-date market price do not qualify as performance based. Ironically, although the objective of the new IRS Section 162(m) was to reduce excessive CEO pay levels by limiting deductibility, the ultimate result (similar to what happened in response to the golden parachute restrictions) was a significant increase in CEO pay. First, since compensation associated with stock options is generally considered performance-based and therefore deductible (as long as the exercise price is at or above the grant-date market price), Section 162(m) encouraged companies to grant more stock options. Second, while there is some evidence that companies paying base salaries in excess of $1 million lowered salaries to $1 million following the enactment of Section 162(m) many others raised salaries that were below $1 million to exactly $1 million. Finally, companies subject to Section 162(m) typically modified bonus plans by replacing sensible discretionary plans with overly generous formulas ( Murphy and Oyer, 2004 ).

53c. Describe how the company would "account" for these options under GAAP following FAS 123R (issued in 2005).

Black-Scholes V alue, 100,000×($35) = $3,500,000 amortized over 4 years or $875,000 per year You multiply black scholes value again

Describe how these options would be treated under IRS Section 409(A).

Can't grant these options under 409A Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan. Section 409A applies to "nonqualified deferred compensation," which it defines very broadly. Basically, this means a present legally enforceable right to taxable compensation fo services that will be paid in a later year. Section 409A can apply to nonqualified retiremen plans, elective deferrals of compensation, severance and separation programs, postemployment payments provided for in an employment agreement, stock options, other equincentive programs, reimbursement arrangements and a variety of other items

FASR Disclosure

Disclosures: Valuation Summary: In this section, you need to report the range and weighted-average value for five values: fair value, volatility, interest rate, expected term and dividend rate. Option Activity: In this section, you need to report nine items that disclose the number of options outstanding at the beginning of the period, the option activity during the period, and several numbers related to the end of the period. Expense Recognition: In this section, you need to report eight items that disclose the amount of expense recognized in the past, the amount to be recognized in the current period, and the expense that is projected to be recognized after the current period. (FASB) that requires companies to deduct the amount of share-based (equity) payment granted to their employees on an annual basis e costs associated with equity payment for employee services are to be expensed on financial statements in order to reflect the economic transaction taking place between a company and its employees If you are a particularly diligent investor or a serious financial newshound, you may have heard of FAS 123R. For those of you who don't know about it, FAS 123R is the 2006 financial accounting standard introduced by the Financial Accounting Standards Board (FASB) that requires companies to deduct the amount of share-based (equity) payment granted to their employees on an annual basis. Here we look at why this accounting standard has come about, what it involves and how it may affect you. Why Introduce this Rule? Many employees receive equity compensation as a supplement to their salaries. Traditionally, this compensation comes in the form of stock option grants, which can be exchanged for shares of the company's stock. The basic idea behind FAS 123R is that the costs associated with equity payment for employee services are to be expensed on financial statements in order to reflect the economic transaction taking place between a company and its employees. (For further reading, see Show And Tell: The Importance Of Transparency.) Equity compensation was not expensed previously because it is not a real monetary expense to a company. However, equity compensation is a direct expense to a company's shareholders. Shareholders are the owners of publicly-traded companies and, therefore, they are the ones who ultimately pay for the issue of extra shares through dilution. When additional shares are issued by a company or convertible securities are converted, dilution occurs. If there were 10 shares in a given company, issuing five more shares for equity compensation would mean that the previous owners of the 10 shares would see their stake in the company reduced to only two-thirds. (To learn more, see The "True" Cost Of Stock Options.) How it Affects You Why should this matter to you as an investor? Well, if you have a lot of money tied up in stocks, FAS 123R has the potential to take a substantial bite out of your portfolio's value. In the past, a company that issued stock options to its employees did not have to expense those options; for example, a grant of 500,000 options to an executive would cost the company nothing on paper. Now, the FASB requires companies to charge the option grant multiplied by the fair value of the grant. Continuing with our example, let's assume that the grant is $10 per option, for a total of $5 million (500,000 options x $10 per option) in equity compensation expense. To be in compliance with FAS 123R, the company now would have to expense this $5 million, thus affecting its financial performance.

58b. Why would expensing lead companies to grant fewer options to fewer employees?

Expensing increases the "perceived cost" -- options will no longer appear to be free. Option expensing (whether voluntarily under FAS123, or by law under FAS123R) significantly leveled the playing field between stock and options from an accounting perspective. As a result, companies reduced the number of options granted to top executives (and other employees), and greatly expanded the use of restricted shares. Expensing options brings the perceived cost of options more in line with their opportunity cost, and companies responded to the robust stock market from 2003 to 2007 Ultimately and predictably, these changes curtailed the practice of broad-based option plans: firms that already had such plans granted fewer options, a

58d.Why would expensing lead companies to favor restricted stock grants over option grants?

Expensing increases the cost of options relative to the cost of restricted stock (the accounting treatment for restricted stock essentially remained intact) The explosion in option grants continued unabated until the burst of the Internet bubble in 2000, followed by a series of accounting scandals that re-focused attention on the accounting treatment of options. Eventually, FASB mandated expensing, and companies moved away from options toward restricted stock. Second, restricted stock can't become worthless like stock options. Even if the stock price falls, restricted stock retains some intrinsic value.A stock option grant with a strike price of $10 has no value when the stock trades at $8. Restricted stock awarded when trading at $10 is still worth $8. A stock option has lost 100% of its value. The restricted stock has only lost 20%. econd, restricted stock can't become worthless like stock options. Even if the stock price falls, restricted stock retains some intrinsic value.A stock option grant with a strike price of $10 has no value when the stock trades at $8. Restricted stock awarded when trading at $10 is still worth $8. A stock option has lost 100% of its value. The restricted stock has only lost 20%.

FASB's 1995 "compromise" rule on accounting for stock options

FASB issued a compromise rule, FAS 123, which recommended but did not require that companies expense the fair-market value of options granted (using Black- Scholes or a similar valuation methodology). However, while FASB allowed firms to continue reporting under APB Opinion 25, it imposed the additional requirement that the value of the option grant would be disclosed in a footnote to the financial statements. Predictably, only a handful of companies adopted FASB's recommended approach. As I will discuss below in Section 3.8.4 , it wasn't until the accounting scandals in the early 2000s that a large number of firms voluntarily began to expense their option grants. The accounting treatment of options promulgated the mistaken belief that options could be granted without any cost to the company. This view was wrong, of course, because the opportunity or economic cost of granting an option is the amount the company could have received if it sold the option in an open market instead of giving it to employees. Nonetheless, the idea that options were free (or at least cheap) was erroneously accepted in too many boardrooms. Options were particularly attractive in cash-poor start-ups (such as in the emerging new economy firms in the early 1990s), which could compensate employees through options without spending any cash. Indeed, providing compensation through options allowed the companies to generate cash, since when options were exercised, the company received the exercise price and could also deduct the difference between the market price and exercise price from its corporate taxes

FAS123R

FASRR leveled the playing field between stock and options Beginning in 2006, FAS123R required all firms to use "fair market value accounting" to value (and account) for stock options FAS123R required firms to record an expense for options granted before this date that were not yet vested (or exercisable) as of this date. a switch from traditional time-lapse restricted stock to "performance shares" that vest only upon achievement of accounting- or market-based performance goals. Angelis and Grinstein (2011), for example, report that 52% of the 2007 restricted stock awards for CEOs

How would the company account for this option grant in its financial statements under the accounting rules in effect between 1995 and 2006 (FAS 123)? (§3.7.4)

Firms can choose to continue using APB 25 (i.e., $125,000 per year for four years) or use fair market value (e.g., Black-Scholes) accounting, under which the Black- Scholes value is amortized over the four-year vesting period. If firms choose APB 25, they must include a footnote in the financial statements showing what the expense would have been under FMV accounting

How would the company account for this option grant in its financial statements under the accounting rules in effect since 2006 (FAS 123R)? (§3.8.4)

Firms must use fair market value (e.g., Black-Scholes) accounting, under which the Black-Scholes value is amortized over the four-year vesting period. (The BS value of this option is $16.77 per option or $1.677 million, which means $419,000 per year).

c) The 1992 SEC disclosure rules for stock options.

From the perspective of many boards and top executives who perceive options to be nearly costless, or indeed deny that options have value when granted, the only way they can quantify the options they award is by the number of options granted SEC's 1992 disclosure rule and also by institutions that monitor option plans. For example, under the current listing requirements of the New York Stock Exchange and the National Association of Security Dealers (NASD), companies must obtain shareholder approval for the total number of options available to be granted, but not for the cost of options to be granted. Advisory firms (such as Institutional Shareholder Services) often base their shareholder voting recommendations on the option "overhang" (that is, the number of options granted plus options remaining to be granted as a percent of total shares outstanding), and not on the opportunity cost of the proposed plan. Therefore, boards and top executives often implicitly admit that the number of options granted imposes a cost on the company, while at the same time denying that these options have any real dollar cost to the company. The focus on the quantity rather than the cost of options granted helps explain a puzzling result in the executive pay literature However, if compensation committees focused on the number of options (e.g. granting the same number of options each year, as opposed to the same "value" of options each year

The executive is the CEO, the bonus was based on a formula communicated to the executive before the beginning of the fiscal year, and the compensation committee consists of three independent outside directors.

Fully deductible After the 1992 election, president-elect Clinton reiterated his promise to define compensation above $1 million as unreasonable, thereby disallowing deductions for all compensation above this level for all employees. February 1993, President Clinton backtracked on the idea of making all compensation above $1 million unreasonable and therefore non-deductible, suggesting that exemptions would be granted if the company could meet (not yet developed) federal standards proving that the executive improved the firm's productivity It concerns deductions for business expenses. It is one of the most important provisions in the Code, because it is the most widely used authority for deductions. Section 162(a) requires six different elements in order to claim a deduction. It must be an 1) ordinary 2) and necessary 3) expense 4) that was paid or incurred during the taxable year 5) in carrying on 6) a trade or business activity non-performance based pay: discount options, restricted stock, salaries, discretionary bonuses

c) The executive is the CEO, and the bonus was discretionary based on the board's subjective assessment of actions the CEO took to settle a lawsuit that could have cost the company billions of dollars.

In addition, Section 162(m) disallows deductions for discretionary bonuses based on a board's subjective assessment of value creation. I suspect that many compensation committees have welcomed the tax-related justification for not incorporating subjective assessments in executive reward systems. Only $600,000 deductible under §162(m). (Discretionary payments not exempt.)

NYSE listing requirements regarding shareholder approval of option plans.

NYSE listing requirements—which required shareholder approval for executive option plans but not broad-based option plans—were also designed to encourage option grants to lower-level employees. The "clarifications" in 1998 (revised in 1999) defined how companies could grant top-executive options without approval, so long as a sufficient percentage of either the eligible employees or options granted were below the top-executive level. As a consequence, grants to both executives and lower-level employees escalated.

Suppose that - in addition to the CEO's 1, 000,000 options - the Board decides to also grant options to all employees. Under the plan, each of the company's 10,000 employees (besides the CEO) would receive 1,000 options (that is, 11 million total options, including the CEO's grant). Would the board need to obtain shareholder approval before making this grant?

No. This plan would be deemed "broad-based" by the NYSE using rules in effect in July 1999, and no shareholder approval is necessary.

The May 1991 SEC ruling on holding periods for stock acquired by exercising stock options.

On May 1, 1991, in response to demands for more transparency of option grants, the SEC defined the acquisition rather than the exercise of the option as the reportable stock purchase. As a consequence of this change, the six-month holding period required by the Securities Act's "short-swing profit" rule now begins when options are granted, and not when executives acquire shares upon exercise. options are exercised more than six months after they are granted, the Executive Compensation: Where We Are, and How We Got There 277 executive is free to sell shares immediately upon exercise

The executive is the CEO, the bonus was based on a formula communicated to the executive before the beginning of the fiscal year, and the compensation committee consists of two independent outside directors plus the company's senior Vice President of Human Resources.

Only $600,000 deductible under §162(m). (Firms must have compensation committee consisting solely of independent directors.)

The firm is privately held by the CEO-owner, and the bonus was discretionary and set by the CEO.

Private firms are exempt from §162(m), Maybe fully deductible under §162(m). (Private firms are exempt from §162(m), though frankly the IRS might worry about "unreasonable compensation" even in this case)

58a. What should happen to stock prices of high option-granting firms when expensing is mandated?

Pro of expense options: Expensing options will provide a level playing field so that companies that use cash bonuses and companies that use stock options each have an expense on the income statement Nothing (unless expensing tells investors for the first time how many options are actually being granted).

Describe how the company would report these options in its proxy statement in both the "Summary Compensation Table" and the "Option Grant Table" under 1992 SEC disclosure rules

Put in 100,000 (number, but not value, of options) Option grant table:, Choice of BS Value or 5%, 10% appreciation) The SEC wanted a total dollar cost of option grants so that the components in the Summary Compensation Table could be added together to yield a value for total compensation, and lobbied for calculating option cost using a Black and Scholes (1973)or related approach In addition, companies would have a choice in the Option Grant Table to report either the Black-Scholes grant-date cost or the potential cost of options granted (under the assumption that stock prices grow at 5% or 10% annually during the term of the option

The bonus was discretionary based on the advice of the company's compensation consultant, and the executive was the senior vice president of human resources (who personally hired the company's compensation consultant, and who was incidentally the sixth highest-paid executive in the firm).

Several Internal Revenue Service (IRS) private letter rulings address how Section 162(m) applies to the compensation that a publicly held corporation's covered employee (see Covered Employees) receives from a partnership in which the corporation has an ownership interest for services the employee performs for the partnership. The IRS ruled that the Section 162(m) deduction limitation does not apply to the Covered employees under Section 162(m) include: The chief executive officer (CEO) (or an employee acting in that capacity) of the corporation. The three highest compensated officers (excluding the CEO and the principal/chief financial officer (PFO/CFO)) Fully deductible under §162(m). (Exec is not a "covered" executive)

The shareholder movement borne out of the takeover market of the 1980s.

Shareholder pressure for equity-based pay. The takeover and LBO market of the 1980s demonstrated vast potential for value creation in previously inefficient firms, leading academics, institutions, and shareholder advocates to demand that pay be more closely tied to shareholder performance. n Section 3.6.2 , the decline in takeover activity in the late 1980s corresponded to the rise in shareholder activism. This new breed of activists—including many of the largest state pension funds—demanded increased links between CEO pay and shareholder returns. The activists were joined by academics such as Jensen and Murphy (1990a) , who famously (or infamously) argued "It's not how much you pay, but how that matters." Jensen and Murphy (1990b)showed that CEOs of large companies were paid like bureaucrats, in the sense that they were primarily paid for increasing the size of their organizations, received small rewards for superior performance, even smaller penalties for failures, and that the bonus components of the pay packages showed very little variability, less even then the variability of the pay of rank-and-file employees. concluded that compensation committees and boards should focus primarily on the incentives provided by the pay package rather than the level of pay, and were joined by shareholder activists such as the United Shareholders Association in advocating more stock ownership and more extensive use of stock options.

Describe how the company would report these options in its proxy statement in both the "Summary Compensation Table" and the "Option Grant Table" under 2006 SEC disclosure rules.

Summary compensation table:, Put in FAS123 expense value for the year The amendment to these rules that the Commission is announcing today will align the reporting of equity awards in the Summary Compensation Table and the Director Compensation Table to the amounts that are disclosed in the financial statements under FAS 123R. FAS 123R requires recognition of the costs of equity awards over the period in which an employee is required to provide service in exchange for the award.

58c. Would the anticipated decline in option grants be good or bad for shareholders?

To the extent that "too many options" were granted to "too many people," this would be good for shareholders

53a. FASB Stock Accounting Options 25

V=Max(0,P0-X) 100,000×($20) = $2,000,000 amortized over 4 years, or $500,000 per year. 20 is from 50, stock price, -30 (exercise price)=20

48b.

Yes, now depends on β, risk-aversion, diversification, 48. a) outside wealth, stock holdings, etc