Accounting Clinic IV
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
With contributions by
Stephen H. Penman – Columbia University
Clinic IV-2
Typical Compensation Plans
Typical compensation plans for employees
have the following components
Base salary
Annual bonus
Stock options
Long-term incentive plans
• restricted stock
(Pension and health benefits are also
provided. See Accounting Clinic VII)
Clinic IV-3
Two Ways of Compensating Employees
with Stock
1. Direct Stock Compensation
Issue stock to employees at less than market
price.
The stock is often restricted until a vesting
date.
2. Stock option compensation
Grant employees stock options that are then
exercised if the stock price is greater than
exercise price after the vesting date.
Clinic IV-4
Direct Stock Compensation
Deferred compensation is recognized for
the difference between market price and
issue price at the time of the stock issue.
Deferred compensation is then amortized to
the income statement over a service
(vesting) period.
The reminder of the clinic deals with stock
option compensation.
Clinic IV-5
Motivation for Using Options in
Compensation
Rewarding performance of current employees
Attracting new employees
Providing incentives to employees to increase
stock price.
Saving on cash reserves.
Deferring taxes - when options are granted not in
the money, they are not taxable to the employees
until they are exercised.
Clinic IV-6
Problems Related to Using Options in
Compensation
Excessive compensation
Motivating employees to take on projects
that are too risky
Motivating employees to manipulate
accounting to hide bad news
Clinic IV-7
Terminology
Exercise price - the price specified in the option contract,
at which the holder can buy the common stock.
Measurement date - The date at which the stock price that
enters into measurement of the fair value of an award of
employee stock-based compensation is fixed.
Vesting period - the time span between option grant date
and the date it becomes exercisable.
Expected life - the time span between grant date and the
time when options are likely to be exercised.
Clinic IV-8
Measuring Compensation for Services
Compensation in the form of stock issued
through employee stock option, purchase,
and award plans should be measured as the
quoted market price of the stock at the
measurement date less the amount, if any,
that the employee is required to pay.
Clinic IV-9
APB 25 – Intrinsic Value
Compensation cost is based on intrinsic
value on the date the option is granted
Intrinsic value = Market price of stock (S) exercise price (E)
Not equal to fair market price of option
If E > = S, no compensation cost recorded
• Most fixed stock option plans - the most
common type of stock compensation plan have no intrinsic value at grant date, and
under Opinion 25 no compensation cost is
recognized for them.
Clinic IV-10
From APB 25 to SFAS 123
APB Opinion No. 25, Accounting for Stock
Issued to Employees, was introduced in 1972. The
main reason for the choice of the described
accounting method was the lack of a reliable
option pricing model.
In 1995, the FASB issued SFAS 123. Its main
goal was to improve stock option accounting, by
estimating the fair value of the option on the date
the option is granted. This was the result of the
following :
The Black and Scholes’ option pricing model had
become a well-established pricing technique.
The increasing popularity of stock options.
Clinic IV-11
The Fair Value Method
Under the fair value based method,
compensation cost is measured at the grant
date based on the value of the award and is
recognized as an expense over the service
period, which is usually the vesting period.
Clinic IV-12
From APB 25 to SFAS 123
When FASB was contemplating changing the
stock compensation accounting method,
advocating the Fair Value Method for all
employee stock options, strong opposition arose.
The opposition's arguments include:
Granting stock options does not represent a cash
outflow and therefore is not an expense.
Lower net income numbers may cause violation of
contract terms, such as debt covenants.
Lower earnings number might lead to stock price drop,
for investors tend to be fixated on P/E and other
valuation ratios.
Firms with large employees stock options programs
might have trouble raising capital (because earnings
would be lower).
Clinic IV-13
SFAS 123
SFAS 123 introduced the fair value method of accounting
for an employee stock option or similar equity instrument
and encouraged all entities to adopt that method of
accounting for all of their employee stock compensation
plans.
However, it also allowed an entity to continue to measure
compensation cost for those plans using the intrinsic value
based method of accounting prescribed by APB 25.
The statement states that the fair value based method is
preferable to the APB 25 method.
Entities that choose to remain with the accounting in APB
25 must make pro forma disclosures (in footnotes) of net
income and, if presented, earnings per share, as if the fair
value based method of accounting had been applied.
Clinic IV-14
SFAS 123R
In 2004, SFAS 123R made it compulsory
for firm to use the fair value method of
SFAS 123, effective for fiscal years ending
in 2006.
So, footnote presentation in no longer
allowed: firms must take the stock options
expense at grant date to the income
statement.
The IASB also passed IFRS 2 with similar
requirements.
Clinic IV-15
Accounting for Stock Compensation
Under SFAS No. 123R
Stock Compensation
Intrinsic
Value
Fair
Value
Intrinsic value
method no longer
allowed.
Clinic IV-16
Black-Scholes Model:
V = SN(d1) – Ee-rtN(d2)
Where ,
S: stock price at option grant date
E: exercise price
t: expected life of options
r: risk-free interest rate
σ: expected volatility of common stock
d1 = [log(S/E) + (r + σ2/2)t]/ σt1/2
d2 = d1 - σt1/2
N(d): value of cumulative standard normal
distribution
Clinic IV-17
Example
On January 1, 2003, Hunter Inc., granted 20,000 options
to executives. Each option allows the executive to
purchase one share of common stock at a price of $25 per
share.
The options were exercisable within a 2-year period
beginning January 1, 2005.
On the grant date, Hunter’s stock was trading at $32 per
share, and a fair value option pricing model determines
total compensation to be $600,000, or $30 each.
On May 1, 2005, 12,000 options were exercised when the
market price of Hunter’s stock was $35 per share. The
remaining options lapsed in 2007 because executives left
the company.
Clinic IV-18
Required
Prepare the necessary journal entries related to the stock
option plan for the years 2003 through 2007.
Hunter uses the fair value approach to account for stock
options, as required by SFAS 123R or IFRS 2.
Clinic IV-19
Solution
01/01/03
No entry
12/31/03
Compensation Expense
Paid-in Capital – Stock Compensation
($600,000 x 1/2)
300,000
Compensation Expense
Paid-in Capital – Stock Compensation
300,000
Cash (12,000 x $25)
Paid-in Capital – Stock Compensation
($600,000 x 12,000/20,000)
Common Stock (12,000 x $10)
Paid-in Capital
300,000
360,000
Paid-in Capital – Stock Compensation
Paid-in Capital
($600,000 - $360,000)
(For lapsed options)
240,000
12/31/04
05/01/05
01/01/07
300,000
300,000
120,000
540,000
240,000
Clinic IV-20
Taxes and Employee Stock Options
Non-Qualifying Options (NQO)
Employees taxed at exercise date on difference
between market price and exercise price.
Company gets tax deduction for same amount
(for compensation expense).
Incentive Stock Options (ISO):
No tax to employee.
No deduction for company.
Clinic IV-21
Employer's tax deduction and employee's taxable
income for Incentive vs. Non-qualifying Options
Grant Date
Stock Price
Exercise Date
Sale Date
S1
S2
Non-qualifying stock
Employer:
--
S1-E
--
Employee:
--
S1-E (Ordinary)
S2- S1(Capital)
Incentive stock
Employer:
--
--
--
Employee:
--
--
S2- E (Capital)
E – exercise price
Clinic IV-22
Tax Consequences
Income tax regulations specify allowable tax deductions
for stock-based employee compensation arrangements
(other then incentive options) in determining an entity's
income tax liability.
Under existing U.S. tax law, allowable tax deductions are
generally measured at a specified date as the excess of the
market price of the related stock over the amount the
employee is required to pay for the stock (that is, at
intrinsic value).
The time value component of the fair value of an option is
not tax deductible.
Therefore, tax deductions generally will arise in different
amounts and in different periods from compensation cost
recognized in financial statements.
Clinic IV-23
Tax Consequences
The cumulative amount of compensation cost
recognized for a stock-based award that ordinarily
results in a future tax deduction under existing tax
law should be considered to be a deductible
temporary difference.
The deferred tax benefit (or expense) that results
from increases (or decreases) in that temporary
difference, for example, as additional service is
rendered and the related cost is recognized, should
be recognized in the income statement.
Clinic IV-24
Tax Consequences
If a deduction reported on a tax return for a stock-based
award exceeds the cumulative compensation cost for that
award recognized for financial reporting, the tax benefit
for that excess deduction should be recognized as
additional paid-in capital.
The same amount is reported as part of Cash
From Financing Activities.
Note that this amount might be very large if stock
prices rise during the vesting period.
Clinic IV-25
Tax Consequences
If the deduction reported on a tax return is less than the
cumulative compensation cost recognized for financial
reporting, the write-off of a related deferred tax asset in
excess of the benefits of the tax deduction, net of the
related valuation allowance, if any, should be recognized
in the income statement except to the extent that there is
remaining additional paid-in capital from excess tax
deductions from previous stock-based employee
compensation awards accounted for in accordance with
the fair value based method in this Statement. In that
situation, the amount of the write-off should be charged
against that additional paid-in capital.
Clinic IV-26
Grant date and Exercise Date
Accounting for Employee Stock Options
Grant date accounting records the
compensation expense as the (fair value)
option value at grant date.
Exercise date accounting records the
expense as the difference between the
market price and exercise price at exercise
date (just as the taxation authorities do).
SFAS 123R uses grant date accounting and
the example above gives a demonstration.
Clinic IV-27
How Exercise Date Accounting Works
1. Recognize the option value at grant date as a
contingent liability, along with a deferred
(unearned) compensation asset. This is the
amount recognized with grant date accounting
under SFAS 123R. The grant date value given to
employees is compensation, but it is contingent
upon the option going into the money. The
deferred compensation asset is similar to that
which arises from stock issues to employees at
less than market value.
2. Amortize the deferred compensation over an
employee service period, usually the vesting
period.
Clinic IV-28
How Exercise Date Accounting Works
(Cont.)
3. Mark the contingent liability to market as
options go into the money to capture the
value of the option overhang, and
recognize a corresponding unrealized loss
from stock options.
4. Extinguish the liability against the share
issue (at market value) at exercise date. If
options are not exercised, extinguish the
liability and recognize a gain from stock
options.
Clinic IV-29
An Example of Exercise Date
Accounting
On January 1, 2004, Peabody Inc. granted
10,000 options to the CEO. These options
allowed the CEO to purchase one share at
$40, the market price on January 1, 2004
(the options are at the money).
The options were exercisable within a 2
year period beginning January 1, 2006.
On grant date the value of the (at-themoney options) totaled $65,000.
Clinic IV-30
On December 31, 2004 the stock price
stood at $45 per share and the total option
value at $105,000.
On December 31, 2005 the stock price
stood at $57 per share and the total option
value at $198,000.
On February 28, 2006, the CEO exercised
the options when the stock price was $68
per share.
Clinic IV-31
Exercise Date Accounting: The
Journal Entries
01/01/04
12/31/04
12/31/04
12/31/05
12/31/05
Deferred Compensation
Liability for Stock Options
65,000
Compensation
Deferred Compensation
($65,000 x 1/2)
32,500
Unrealized Loss on Stock Options
Liability for Stock Options
($105,000 - $65,000)
40,000
Compensation
Deferred Compensation
($65,000 x 1/2)
32,500
Unrealized Loss on Stock Options
Liability for Stock Options
($198,000 - $105,000)
93,000
65,000
32,500
40,000
32,500
93,000
Clinic IV-32
Exercise Date Accounting: The
Journal Entries
01/01/04
Cash
(10,000 x $40)
Liability for Stock Options
Loss on Stock Options
Paid in Capital
(10,000 x $68)
400,000
198,000
82,000
680,000
The liability is extinguished and the difference between the
carrying value of the liability (plus cash) and the market value of
the shares is an additional loss.
Clinic IV-33
The difference between the market price
and the exercise price at exercise date,
$280,000, was recognized as the total loss,
as follows:
Compensation, 2004
Compensation, 2004
Unrealized Loss, 2004
Unrealized Loss, 2005
Loss, 2006
$32,500
32,500
40,000
93,000
82,000
$280,000
Clinic IV-34
Equity Valuation and Stock Option
Accounting
With the shareholders in mind, the
appropriate accounting is exercise date
accounting. This gives the value
surrendered by shareholders to compensate
employees.
Go to Chapter 8 of the text for the
explanation.
Chapter 13 shows how to correct the GAAP
accounting when valuing the company.
Clinic IV-35
Restricted Stock
See the Web Page for Chapter 9 for a
discussion of how restricted stock works.
Clinic IV-36