Stock Based Compensation (Chapter 16)

Stock Options (Employee Stock Options)

-gives you the right to buy a set number of shares at a fixed price for a finite period of time, but you don't have to own the shares · Employee stock options are a type of equity compensation granted by companies to their employees and executives · Rather than granting shares of stock directly, the company gives derivative options on the stock instead o These options come in the form of regular call options and give the employee the right to buy the company's stock at a specified price for a finite period of time · Terms of the ESOs will be fully spelled out for an employee in an employee stock options agreement o ESOs can have vesting schedules which limits the ability to exercise · Stock Option plans involve two main accounting issues: o 1. How to determine compensation expense o 2. Over what periods to allocate compensation expense

Steps for Stock Based Compensation Problems:

1. Determine the fair value of the award at grant date 2. Determine the amount of shares expected to vest (estimating forfeiture rate (if any)) 3. Determine the period which the awards will be earned, which is the service period 4. Record compensation expense for the fair value of awards expected to vest over the period the awards will be earned RULE --> expense can be ahead of vesting but vesting cannot be ahead of expense

Measurement of Stock Compensation Plan Rule

General rule: for stock based compensation the accounting objective is to 1. determine the fair value of compensation at grant date 2. expense the compensation over a period in which employees perform services

2 common types of stock-based compensation

restricted stock awards and restricted stock units

Incentive Stock Options (ISOs)

· Allow employers to purchase shares at a fixed price (exercise price) for a given period, regardless of the current price in the market · The ISOs provide value if the actual share price is more than the exercise price. If the actual share price is less than the exercise price, stock options currently lose value. · When ISOs are exercised, the stocks are bought at a pre-defined price, which can be way below the actual market stock price o The income does not need to be reported when a stock grant is received or when the option is exercised o The taxable profits are only reported when stocks are sold o Based on the time a stock is owned, the profits are taxed at capital gain rates which is usually lower than the normal income tax rate

Stock Appreciation Rights (SARs)

· Are a type of employee compensation linked to the company's stock price during a predetermined period and they offer the right to cash equivalent of a stock's price gains over a predetermine time interval · Are profitable for employees when the company's stock rises, which makes them similar to employee stock options. However, employees do not have to pay the exercise price with SARs instead they receive the sum of the increase in stock or cash · The primary benefit of SARs is that employees can receive proceeds from stock price increases without having to buy stock · SARs are often paid in cash and do not require the employee to own any asset or contract · SARs are beneficial to employers since they do not have to dilute share price by issuing additional shares · In most cases employees can exercise SARs after they vest (when SARs vest they become available to exercise) & they assist in funding the purchase of options and help pay off taxes due at the time the SARs are exercised

Black Scholes Model (item that affect the Fair Value)

· Is a mathematical model for pricing an options contract. The model estimates the variation over time of financial instruments o It assumes these instruments (such as stocks or futures) will have a lognormal distribution of prices o Using this assumption and factoring in other important variables, the equation derives the price of a call option · Under the FVM, the company computes total compensation expense by applying an acceptable fair value option-pricing model (such as the Black-Scholes option-pricing model)

Non-Qualified Stock Option (NQs)

· Is a type of stock option used by employers to compensate and incentivize employees (it is also a type of stock-base compensation) · Holders are required to pay taxes based on the price of the stock at the time when the options are exercised · IMPORTANT remember the price of the stock at the grant date because profits are determined by the difference between the price of stock at grant date and the price at which the options are exercised (intrinsic value)

Stock Based Compensation

· Is a way corporations use stock options to reward employees · Is often subject to vesting period before it can be collected and sold by and employee · Employees with stock options need to know whether their stock is vested and will retain its full value even if they are no longer employed at the company · Because tax consequences depend on the fair market value (FMV) of the stock, if the stock is subject to tax withholding, the tax must be paid in cash, even if the employee was paid by equity compensation

Cliff Vesting

· Is the process by which employees earn the right to receive full benefits from their company's qualified retirement plan account at a specified date, rather than becoming vested gradually over a period of time o The vesting process applies to both qualified retirement plans and pension plans offered to employees · Refers to the vesting of employee benefits over a short period of time · Startups use cliff vesting commonly because it helps them evaluate employees before actually committing to a full range of benefits

Graded Vesting

· Is the process by which employees gain, over time, ownership of employer contributions made to the employee's retirement plan account, traditional pension benefits, or stock options · Vesting employees of a gradual period of time instead of all at once · Encourages employee loyalty since the vesting plays out over a few years of continuous employment

Strike or Exercise Price

· Is the set price at which a derivative contract (an underlying asset) can be bought or sold when it is exercised · For call options, the strike price is whether the security can be bought by the option holder · For put options, the strike price is at which the security can be sold · The difference between the exercise price and underlying security's price determines if an option is "in the money" or "out of the money"

Vesting

· Means you have to earn your shares over time · Companies use vesting to reward employees for the years worked at a business and for helping the firm reach its financial goals · RSA vesting o Because you legally own RSA shares when they are granted to you, vesting only impacts whether the company can repurchase your shares if you leave or are terminated · RSU vesting o RSU shares are not issued to the recipient until they vest o When a company grants RSUs, they are promising to issue those shares at a later date based on the vesting schedule o RSUs can have multiple vesting conditions

Intrinsic Value Method

· Measures compensation cost by the excess of the market price of the stock over its exercise price at the grant date (it measures what the holder would receive today if the option was immediately exercised) · is the difference between the market price of the stock and the exercise price of the options at the grant date o Using this method company's would not recognize any compensation expense related to your options because at the grant date the market price equaled the exercise price (with this method some people believed stock options had no value) -used before 2006 (current price minus strike price)

Restricted Stock Units

· RSU is a common stock that will be delivered at a future date, contingent on vesting and performing conditions (RSU shares are not received until the restrictions lapse) o It is a promise by an employer to grant an employee a given number of shares of the company's stock · Unlike RSAs, when the shares are "owned" by the employee on the grant date, an RSU is a promise from the company to give an employee shares at a later date · The date you actually receive your RSU shares can be a vesting date, a liquidation event, a specified date in the future, or some combination of these. The future date is established when the RSU is granted. · Another key difference from an RSA is that the RSU holder does not pay anything to own the shares (outside of applicable taxes)

Restricted Stock Awards

· Shares that you cannot buy or sell until a certain date after you earn your shares o Most common restrictions are time based involving a vesting schedule o If an employee leaves the company can repurchase the stock · RSA shares are given to employees on the day they are granted. RSAs are typically issued to early employees before the first round of equity financing, when the FMV of common stock is very low. RSAs provide the individual the right to purchase shares at FMV, at a discount, or at no cost on the grant date · The employee "owns" the stock associated with the RSA on the grant date, but may still have to purchase them depending on the nature of the offer, and the stock is restricted because you still need to earn them

Fair Value Method

· Under the FVM companies use acceptable option-pricing models to value the options at the date of grant o These models take into account the many factors that determine the option's underlying value · GAAP requires that companies recognize compensation cost using the fair value method · FASB says that companies should base the accounting for the cost of employee services on the fair value of the compensation paid o This amount is presumed to be a measure of the value of the services received · Fair value applies to both stock options and restricted stock plans · Under the fair value method, companies compute total compensation expense based on the fair value of the options expected to vest on the date they grant the options to them employer o Public companies estimate fair value by using an option-pricing model · Allocating compensation expense o A company recognizes compensation expense in the periods in which its employees perform the service (the service period) § The service period is the vesting period - the time between the grant date and the vest date o Thus the company determines the total compensation cost at the grant date and allocates it to the periods benefited by its employee's services

Forfeitures

· Under the terms of a contract, refers to the requirement by the defaulting party to give up ownership of an asset, or cash flows from an asset, as compensation for the resulting losses to the other party · Employee fails to satisfy a service requirement · When this happens the company should adjust the estimate of compensation expense recorded in the current period o A company records this change in estimate by debiting Paid-in Capital - Stock Options and crediting Compensation Expense for the amount of cumulative compensation expense recorded to date (thus decreasing compensation expense in the period of forfeiture)

Grant Date

· is the date on which a stock option or other equity-based award is granted to the recipient · it is the date which an employer and an employee agree upon the most essential terms and conditions associated with the award

Stock Awards

· with stock awards you receive the company's stock as compensation and depending on the type of stock you may have to wait for a certain period before you can fully own it · a stock option on the other hand only gives you the right to buy the company's stocks in the future at a certain price (this way you can buy the stocks below market price if the stock price increases)