WASHINGTON AREA
COMPENSATION AND BENEFITS ASSOCIATION
FAS 123: REGULATORY IMPACT AND
COMPENSATION PROGRAM DESIGN
IMPLICATIONS
Robert S. Timmerman
Consultant, New York Office
Frederic W. Cook & Co., Inc.
November 21, 2002
Today’s Discussion

Discussion scope
–
Background
 Opinion 25 Versus FAS 123
–
Implications
 Possible Outcomes and Reactions
–
Action Steps
 How to Respond

Focus on employee stock options in particular
2
Background

Expense – generally defined in accounting terms as the
expenditure of an asset or incurring of a liability

Current U.S. GAAP permits stock option expense to be determined
under either:
–
APB Opinion No. 25 – published October 1972
 Interpretation No. 44 issued in March 2000
–
FAS Statement No. 123 – published October 1995
 Choice with disclosure


Generally no expense recognized under Opinion 25, assuming:
–
Option exercise price equals FMV at grant (“intrinsic value
accounting”)
–
Vesting is contingent solely on the passage of time
Significant accounting bias in favor of plain vanilla option awards
3
Executive Long-Term Incentive Grant
Type Usage Percent of Top 250 Companies
100%
99%
80%
56%
60%
51%
43%
40%
32% 33%
30%
24%
21%
20%
0%
Stock Options
Restricted
Stock
1999
Source: Frederic W. Cook & Co.
2000
Performance Performance
Shares
Units
2001
4
Executive Stock Option Variations
Percent of Top 250 Companies
20%
18%
16%
15%
9%
10%
6%
5%
2%
0%
Performance
Options
Premium Options Discount Options
1999
Source: Frederic W. Cook & Co.
2000
2001
5
Background (cont’d)



FAS 123 is based on “fair value accounting” such that expense
equals the “fair value” of the option at grant and is recognized over
the vesting schedule
–
Fair value is generally determined using an option pricing
model (e.g., Black-Scholes, binomial)
–
Model includes 6 valuation inputs (stock price, exercise price,
dividend yield, interest rate, option term and volatility)
–
Also includes forfeiture rate factor
Implications:
–
Opinion 25: must disclose the pro forma impact under FAS
123 as a footnote in the annual report
–
FAS 123: the decision applies to all equity compensation
awards and is irrevocable
How do reported financial results differ as a result of a company’s
election?
6
1
25 LARGEST U.S. COMPANIES
IMPACT OF FAS STATEMENT 123
Company Name
General Electric
Microsoft
Exxon Mobil
Wal-Mart Stores
Pfizer
Citigroup
American International Group
Johnson & Johnson
Intel
Coca-Cola
Intl Business Machines
Procter & Gamble
Merck
Berkshire Hathaway
Bank Of America
Philip Morris
Cisco Systems
SBC Communications
Verizon Communications
Wells Fargo
ChevronTexaco
Pepsico
Fannie Mae
Home Depot
Viacom
75th Percentile
Median
25th Percentile
Reported
Diluted
EPS3
$1.41
1.38
2.18
1.49
1.22
2.75
2.07
1.84
0.19
1.60
4.35
2.07
3.14
521.00
4.18
3.88
(0.14)
2.14
0.22
1.97
3.70
1.47
5.89
1.29
(0.13)
2
EPS Impact
FAS 123
FAS 123
Cost
Diluted
Per Share
EPS3
($0.03)
(0.41)
(0.04)
(0.02)
(0.09)
(0.11)
(0.05)
(0.08)
(0.15)
(0.08)
(0.70)
(0.22)
(0.17)
0.00
(0.22)
(0.08)
(0.23)
(0.07)
(0.18)
(0.08)
(0.08)
(0.17)
(0.24)
(0.10)
(0.08)
$1.38
0.97
2.14
1.47
1.13
2.64
2.02
1.76
0.04
1.52
3.65
1.85
2.97
521.00
3.96
3.80
(0.37)
2.07
0.04
1.89
3.62
1.30
5.65
1.19
(0.21)
Percentage
Change
-2%
-29%
-2%
-1%
-7%
-4%
-3%
-5%
-79%
-5%
-16%
-11%
-6%
0%
-5%
-2%
-168%
-3%
-83%
-4%
-2%
-12%
-4%
-8%
-60%
-3%
-5%
-12%
1
Based on market capitalization
Based on most recent 10-k
3
Before extraordinary items
2
7
Background (cont’d)

IASB Exposure Draft – November 7, 2002

FASB’s Invitation to Comment – November 18, 2002
–
Aim is global convergence
1. Differences between FAS 123 and IASB’s ED
 Forfeitures
 Tax benefits
 Private company volatility assumption
 IASB’s proposed principles-based valuation
approach

–
Ideas on “ways to improve consistency and comparability of
option grant values”
–
Option valuation methodologies up for reevaluation
New standard effective January 1, 2004
8
Black-Scholes Overestimates Option Value

Designed for traded options
–

Employee options are illiquid
Use of “expected” (instead of maximum) term does not
adequately reflect nontransferability
–
Penalizes companies with high volatility

Does not recognize value impairment from non-exercisability
before vesting and truncated terms at termination of
employment

Employees cannot hedge or “borrow stock and short it against
the option”
9
Black-Scholes Overestimates Option Value (cont’d.)


Employees discount Black-Scholes values
–
Risk aversion and portfolio diversification reasons
–
Value differential between company cost and
employee’s perceived value
Option gains are taxable income and deductible
–

No so for traded options
Executives’ options often have restrictive features
–
Blackouts, no sales, holding periods, forfeitures for
competing, etc.
10
Comparative Black-Scholes Option Values
DJIA 30
B-S as
Volatility % FMV
Nasdaq 100
Volatility
B-S as
% FMV
75P
40.0%
40.3%
86.6%
78.2%
50P
35.6%
35.2%
71.5%
70.2%
25P
31.1%
29.8%
52.7%
57.5%
Note: Assumes 7-year term, 4% interest rate and average 5-year volatility
11
Primary Criticisms of Opinion 25


General public perception that stock options, and their
accounting treatment, contributed to:
–
Recent corporate scandals (Enron, WorldCom etc.)
–
Speculative bubble in stock prices
Critics contend that:
1. Absence of expense leads to:
– Increasingly large grants
– Excessive shareholder dilution
– General lack of accountability for “cost”
– Overstatement of earnings
12
Primary Criticisms of Opinion 25 (cont’d)

Critics further contend that:
2. Large annual option grants lead to:
– Excessive focus on short-term stock price
performance
– Diverging management and shareholders interests
– Temptation to falsify financial results
– May reward even poor-performing executives
because a rising market lifts all stocks

Expensing is the panacea to address current bad stock
option practices
13
Arguments Against Expensing

The “cost” of options is already reflected in diluted EPS and
reduced share prices (double-counting argument)
–
Reflects the share equivalents attributable to
outstanding “in-the-money” options

Options are a capital transaction between shareholders and
employees (transaction is a division not a subtraction)

There are no cash flow costs associated with stock options
–
Rather, options provide positive cash flow (exercise
price, tax benefit)

There is no way to “accurately” value stock options, so doing
so will undermine the credibility of financial statements in
terms of comparability and transparency

Expensing of options would discourage their use and
mitigate creative thinking and innovation, especially for
entrepreneurial start-up companies
14
Arguments For Expensing

Stock options are compensation and compensation is an
expense
–
“If options aren’t a form of compensation, what are they? If
compensation isn’t an expense, what is it? And if expenses
shouldn’t go into the calculation of earnings, where in the
world should they go?” (Warren Buffet argument)

Options have value when granted, and retain value even if
they fall underwater

Sale of stock at less than current FMV results in an
opportunity cost to the company, which depletes assets

The accounting treatment for options under Opinion 25 is
inconsistent with that of all other forms of compensation

Stock options do create cash flow expenses if shares are
bought back in market to neutralize dilution effect
15
Arguments For Expensing (cont’d)
A simple example – “cost” of 100 options versus 100 SARs

Assume $10 exercise price; award exercised at $20; 35% corporate
tax rate

Economic impact to employee - $1,000 gain
–


[$20-$10] x 100
Dilutive effect to Company
–
None under SAR
–
100 shares under option (neutral if shares bought back)
Cash Flow analysis
Payment of exercise price
Payment to employee
Tax benefit
Cost of share purchase
Total cash flow cost
SAR
Option
0
($1,000)
350
0
($650)
$1,000
0
350
($2,000)
($650)
16
Constituencies For and Against an Expense
For a P&L Change
Against a P&L Change
Alan Greenspan
President Bush
Former SEC Chair A. Levitt
Former SEC Chair H. Pitt
Senators McCain and Levin
Senator Lieberman
Warren Buffett
Cisco, Intel, et. al.
The FASB
The IASB
The Council of Institutional Investors
TIAA-CREF
Growing list of public companies
17
Possible Outcomes

3 possible scenarios
1. Voluntary adoption – investor pressure and competitive
precedent
2. SEC or FASB mandate – likelihood increasing daily
– Widespread political support
– IASB – need for a global standard and call for fair
value approach
– Leverage attributable to voluntary adoptions
3. Status quo – seems highly unlikely, but perhaps
possible

Outcome may largely depend on “herd mentality” in keeping
up with competitive compensation practices
18
Companies Recently Adopting FAS 123

As of November 20, approximately 125 public companies
are “early adopters”

High profile companies include:
American Express
General Electric
American International Group
General Motors
Citigroup
Goldman Sacs
Coca-Cola
Home Depot
Computer Associates
Procter & Gamble
Dow Chemical
United Parcel Service
Emerson Electric
Wal-Mart Stores
19
How to Respond

What to do now
1. Examine the impact of adopting FAS 123
– 3 transition approaches
A. Prospective method (new grants only, but sunset
approach for companies not adopting early by
FY ‘04)
B. Modified Prospective method (new statements
reflect all grants subject to vesting)
C. Modified Retroactive method (full restatement of
prior results)
2. Compare impact relative to peers
3. Discuss issue with industry peers
– If a trend develops, could it be resisted?
20
How to Respond (cont’d)

What to do now (cont’d)
4. Examine financial efficiency of existing program under
FAS 123
– For example, do reloads remain affordable?
– Only elect FAS 123 if it reduces otherwise disclosed
expense
5. Consider alternative option and full-value LTI designs
6. Start voluntary quarterly pro forma option expense
disclosure
7. Use lowest reasonable Black-Scholes value for expense
8. Adopt dilution-based grant guidelines
9. Run ISS methodology if you need more shares
21
Black-Scholes Input Assumptions
We must all become better informed quickly
Pfizer base case option @ $33 on 9/1/02, 5 year term, 5 year
monthly volatility/yield, and 5 year STRIP interest-rate
+/- Base Case
Base Case Option
Option Value
per
Total for
Intrinsic
per Share
Share
79.1M Shs.
Value
$7.91
--
--
--
Weekly 5 Yr. Volatility/Yield
$10.44
+$2.53
+$200.1M
--
Monthly 3 Yr. Volatility/Yield
$6.99
-$.92
-$72.8M
--
Base Case @ $10 Discount
$13.00
+$5.09
+$402.6M
+$791.0M
Base Case @ $10 Premium
$4.75
-$3.16
-$250.0M
-$791.0M
22
Option Provisions
Relatively more attractive under FAS 123
Provision
Advantage to NQSOs
Stock SARs
Fewer shares issued
Discount Price
Low cost to intrinsic value
Combined Dividend Rights
Low cost to intrinsic value
Performance Vesting
Pay-for-performance
Indexed Price
Pay-for-performance
23
Option Provisions (cont’d)
Relatively less attractive under FAS 123
Provision
Disadvantage to NQSOs
ISOs
No tax benefit
Reloads
Additive cost
Cash SARs
Variable cost
Premium Price
High cost to intrinsic value
24
Conversion of Option Values
Converting high Black-Scholes values to cash, full-value
shares, and SERPs is appealing but wrong without discount
Recent
Black-Scholes
Equivalent Cash/
Price
Multiple
Full-Value Shares
AOL
$13.00
52.37%
$6.81
Citigroup
$30.00
22.15%
$6.65
Intel
$16.00
49.53%
$7.92
3M
$120.00
25.08%
$30.10
$2.50
34.49%
$.86
United Airlines
25
Full-Value Shares
Better than options for matching disclosed or real expense
with delivered after-tax value
Assume 40% Black-Scholes value, 35% company
tax rate, and 45% individual rate
Per $1 of Grant Value
NQSOs
Full-Value Shares
FAS 123
Pay
FAS 123
Pay
Stock Price
Expense
Delivered
Expense
Delivered
Declines 50%
$.65
$.00
$.65
$.28
No Change
$.65
$.00
$.65
$.55
Increases 50%
$.65
$.69
$.65
$.83
Doubles
$.65
$1.38
$.65
$1.10
26
Likely Impact on Incentive Design

Short-term (irrespective of FAS 123)
–
Decreased use of options in aggregate, even in the absence
of a direct earnings charge
 Investors, rating agencies, and Wall Street analysts
already considering pro forma FAS 123 impact
–
Reduced use of reload stock options
–
Reduced share usage will Increase use of cash- and stockbased “full value” LTI alternatives, particularly among senior
executives
 Risk that middle management and rank-and-file are left
behind (also made worse with FAS 123 ESPP treatment)
–
Heavy emphasis on time-based restricted stock, with
mandatory hold and delayed payout
–
Decreased use of surveys to determine grant levels
 More reliance on dilution-based approaches
27
Likely Impact on Incentive Design (cont’d)

Anticipated stock option evolution (assuming FAS 123 mandate)
–
Significant changes in the design of option awards (maybe)
 Performance contingent vesting
 Indexed exercise price
 Shorter terms, perhaps with immediate vesting, but longer
vesting helps spread expense
 Barrier options such as exercise trigger options
–
Replacement of traditional options with stock-based SARs and
variations
 Same accounting treatment under FAS 123
 Simpler to administer (no cashless exercise)
 Less burden on equity plan share reserve (profit shares)
–
Replacement of FMV options with discount options
 Fair value is less than sum of discount plus fair value of
option at 100% of FMV
28
Macro Impact

Overall assessment
–
Expensing of options creates level playing field for all
incentives (positive result for private companies)
–
Earnings charge raises level of accountability for “cost”
–
Long-term result should be less options and more
performance-based full-value approaches
–
Enhanced focus on long-term operating results
–
Greater line of sight between executive performance and
wealth creation opportunities
–
Improved retention and decreased pressure to make special
awards to address unexpected circumstances (e.g.,
underwater options, industry recession)
–
Decreased pressure from institutional investors regarding
potential share dilution
–
Improved public perception regarding executive pay;
restoration of investor confidence
29
Company Profile
Frederic W. Cook & Co., Inc. provides management compensation consulting services to
business clients. Formed in 1973, our firm has served over 1,300 corporations in a wide variety of
industries from our offices in New York, Chicago, and Los Angeles. Our primary focus is on
performance-based compensation programs which help companies attract and retain key employees,
motivate and reward them for improved performance, and align their interests with shareholders. Our
range of consulting services encompasses the following areas:
• Total Compensation
Review
• Strategic Incentives
• Specific Plan Reviews
• Restructuring Services
• Competitive Comparisons
• Incentive Grant Guidelines
• Executive Ownership
Programs
• All-Employee Plans
• Directors’ Compensation
• Equity Instruments
•
•
•
•
New York
Chicago
Los Angeles
90 Park Avenue
35th Floor
New York, New York 10016
212-986-6330 (phone)
212-986-3836 (fax)
19 South LaSalle Street
Suite 400
Chicago, Illinois 60603
312-332-0910 (phone)
312-332-0647 (fax)
2029 Century Park East
Suite 1130
Los Angeles, California 90067
310-277-5070 (phone)
310-277-5068 (fax)
Performance Measurement
Globalization
Privatization
Compensation Committee
Advisor
• Stock Option Enhancements
Our offices are located:
Website address:
www.fwcook.com
30