Stock-based Compensation
February 2004
Stock-based Compensation
Instructor
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Brad Owen - Partner, KPMG LLP
CA - 1995; CPA (Illinois) - 1999
Specialize in US GAAP and SEC reporting
Two-year secondment to Department of Professional Practice
in New York (10/03)
Review US GAAP reconciliations for a number of public
companies in Canada
Clients included Siemens AG, Amtelecom Income Fund,
Century II Holdings, CPI Plastics Group Inc., Stuart Energy
Systems Corporation
February 2004
Stock-based Compensation
Agenda
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What is it?
Why do we care?
Basic accounting issues
Accounting models
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February 2004
G4+1 Proposal
FASB
CICA (2002 and 2004)
IASB (November 2002)
Recent Standard Setter Developments
Investors’ concerns
Stock-based Compensation
What is Stock-based Compensation

Consideration given in return for goods or
services
- Employee or non-employee
- Consideration can be options, direct share awards or
liabilities indexed to common shares
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February 2004
Excludes shares issued for cash (IPO’s)
Stock-based Compensation
Why Do We Care?

Stock-based arrangements are front and centre
in the press
∽ 90 % of TSE 100 companies have at least one
equity-based program for directors
 7 of 99 provide only options as remuneration
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February 2004
Stock-based Compensation
Why Do We Care?
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47% make annual option grants
Growth in option-based awards expected to continue
Canadian public companies must use fair value method
after 1/1/04
Many companies in the US are responding to pressures
and are voluntarily adopting the fair value method
February 2004
Stock-based Compensation
Value of New Options—US Data
2000
1800
1600
1400
1200
1000
Value per
em ployee
800
600
400
200
0
1994
1995
*Based on 144 large S&P 500 firms
February 2004
1996
1997
1998
Source: US Federal Reserve Board
Stock-based Compensation
Income Statement Impact
Company (Y/E)
Agrium ‘01
Alberta Energy ‘01
ATI Techn. ‘00
CN Rail ‘01
Celestica ’01
Four Seasons ‘01
Noranda ‘00
Nortel ’01
Rogers ‘01
Shaw ‘00
Basic EPS(1)
($0.49)
5.24
(0.47)
5.41
(.40)
1.65
3.77
(8.56)
(2.16)
0.35
Proforma EPS(1)
($0.51)
5.06
(0.53)
5.37
(0.45)
0.77
3.52
(9.08)
(2.31)
0.33
% Change
(4.08%)
(3.4%)
(12.77%)
(0.74%)
(12.5%)
(53.33%)
(6.63%)
(6.07%)
(6.94%)
(5.71%)
Computer Ass. ’02
GE ’01
Microsoft ‘01
(1.91)
1.38
1.38
(2.05)
1.35
0.95
(7.33%)
(2.17%)
(31.16%)
February 2004
(1) US GAAP
Stock-based Compensation
Goals of Plans—R3
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Retention
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Rewarding performance
-
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Qualitative goals
Quantitative goals
Recruiting in New World economy
-
February 2004
Medium to long-term plans
There are certain tax benefits
Upside potential was significant and avoided the use of cash
resources to companies
Stock-based Compensation
Effectiveness of Plans
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“Time” alone is not a performance enhancer
Employees typically don’t hold shares
-
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Roth/Nortel
Drives behaviors that focus on short-term appreciation
in stock price
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February 2004
Pump and dump (Enron allegation)
Stock-based Compensation
Effectiveness of Plans
2001 CEO
Ownership ($
millions)
1-year EPS
Growth
Ownership to
Salary
1-year TRS
(1)
ROE
High
$30.0
51.6:1
20.7%
14.9%
17.6%
Low
All
$1.8
$7.0
3.4:1
11.1:1
0.0%
11.0%
11.7%
13.4%
10.7%
14.2%
Based on stock owned at the beginning of 2001
CEOs in high ownership group had a medium ownership stake of $30M
CEOs in low ownership group had a medium ownership stake of $1.8M
(1) Total return to shareholders
February 2004
Stock-based Compensation
Basic Accounting Issues
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How to measure it?
- Initially
- Subsequently
When does it get recognized, if at all?
 How to present it?
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February 2004
Stock-based Compensation
Measurement Issues
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Measurement amount:
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Measurement dates:
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February 2004
Fair value
Intrinsic value
No value/historical cost (“Settlement accounting”)
Grant date
Service period
Vesting date
Exercise date
Stock-based Compensation
Measurement Amount—
Stock Options
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Fair value = IV + Time Value
-
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Intrinsic value (IV) = market price of underlying –
exercise price
-
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February 2004
Willing buyer/willing seller
Quoted market price (QMP)
Estimation models
Can never be negative
Can be zero
Historical cost = 0
Stock-based Compensation
To Measure or Not to Measure
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Options have value, even when issued out of or at the
money
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Cash paid for employee services is not ignored
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February 2004
Inability to transfer doesn’t negate value
They’re not free to employee or the entity
Have value even if not exercised
Measurement difficulties
Why should medium of exchange matter
Stock-based Compensation
Which Measurement Basis?
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Reciprocal transactions generally are measured at FV
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E.g., business combinations consummated with shares not
considered a capital transaction
Intrinsic value method leads to financial engineering in
US
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February 2004
APB 25: no compensation cost recognized at all
Inconsistent with the goals of the plans
Stock-based Compensation
Option Pricing Models
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Black-Scholes
Binomial
Example:
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Share and exercise prices = $10
Expected life of option = 5 years
Expected volatility = 60%
Risk-free rate = 3%
Fair value = $5.35
February 2004
Stock-based Compensation
Option Pricing Model Assumptions
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Exercise price
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Expected life of option
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February 2004
higherhigher FV
Expected dividend yield
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higherlower FV
Expected volatility
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longerhigher FV
Current price (FV) of underlying stock
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higherlower FV
higherlower FV
Risk-free rate during term of option
-
higherhigher FV
Stock-based Compensation
Measurement Problems—
Option Pricing Models
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Gaming through assumption manipulation
- Reverse engineer FV
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Even with the simple plans
- Difficult to estimate volatility; projected dividend yield;
expected life as history is not always necessarily a good
indicator of the future
February 2004
Stock-based Compensation
Measurement Problems—
Option Pricing Models
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Forfeiture provisions
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Non-transferability
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Employees value stock less than cash
FASB focus on value to entity
Capital structure effects
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February 2004
Need to estimate and adjust for probability
Issuer to exchange traded options not the entity
Stock-based Compensation
US Reaction to Proposed FV Model
(Mid 1990’s)
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Vociferous lobbying of the FASB
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Focus on recognition, not disclosure
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Information inefficiency???
Non-binding Senate resolution opposing FV model
Changed to FV-disclosure option (except nonemployee options)
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February 2004
Negative market impact on stock prices
Definition of non-employee broad
Stock-based Compensation
Measurement Dates
Grant date
 Service date
 Vesting date
 Exercise date
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February 2004
Stock-based Compensation
Grant Date
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Date employer and employee come to mutual
understanding of the terms
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Can’t occur prior to start date
Can’t occur prior to shareholder approval, if required or requested
Subsequent changes in value ignored
Earliest measurement date—”cheapest” cost if share
prices rising
February 2004
Stock-based Compensation
Service Date
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Measure as recipient performs service:
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Theoretically 365 measurement dates in a year of service
Subsequent changes in value ignored for units already
recognized
Final measure will be approx. equal average share price
in the period
February 2004
Stock-based Compensation
Vesting Date
Date award vests
 Interim changes in value considered
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- Variable accounting
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“Expensive” relative to grant or service dates in a
rising market
February 2004
Stock-based Compensation
Exercise Date
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Date award is exercised
May be years after service rendered to earn award
Changes in interim period considered
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February 2004
Variable accounting
Post-vesting and post-employment
Most expensive date in rising market
Stock-based Compensation
Example
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Assume 750 options are granted
Exercise price is $15 and QMP is $15
EOY QMPs: $16; $17; $18
Fair value is $3 on grant date
EOY FVs: $4; $5; $6
Vest over 3 years
Term 10 years: FV and QMP at end of term $20 and $35,
respectively
February 2004
Stock-based Compensation
Compensation Cost
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Grant date:
- $2,250= $3*750 options if FV used
- Nil if intrinsic value is used
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Service date:
- $3,750 if FV used
• ($4*250)+($5*250)+($6*250)
- $1,500 if intrinsic value used
• (($16-$15)*250)+(($17-$15)*250)+(($18-$15)*250)
February 2004
Stock-based Compensation
Compensation Cost
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Vesting date
- $4,500 = $6*750 options if FV used
- $2,250 if intrinsic value is used
• ($18-$15)*750
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Exercise date:
- $15,000 if FV used
• $20*750
• No time value remains when exercised at expiry date
- $15,000 if intrinsic value used
• ($35-$15)*750
February 2004
Stock-based Compensation
Comparison
Fair value
Intrinsic value
February 2004
Grant date
Service date
Vesting date
Exercise date
$2,250
$3,750
$4,500
$15,000
Nil
$1,500
$2,250
$15,000
Stock-based Compensation
Authoritative Bodies
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IASB—International Accounting Standards
Board
- Principle-based guidance
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FASB—US Financial Accounting Standards
Board
- Rule-based guidance
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CICA
- Principle-based guidance
February 2004
Stock-based Compensation
IASB Model (2000)
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February 2004
G4+1 paper
Fair value measurement model
Recognition at the vesting date
Variable accounting in interim periods
The type of recipient is irrelevant
Stock-based Compensation
Current FASB Model
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Employee plans:
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Fair value at grant date (FAS 123) or
Intrinsic value at measurement date (APB 25):
• Variable plan accounting: “bad” result
• Fixed plan accounting: “good” result
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Non-employee:
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Fair value
Performance completion date
• Under reconsideration by EITF
February 2004
Stock-based Compensation
Current FASB Model
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February 2004
APB 25 (1972)
- Numerous practice interpretations
SFAS 123 (1995)
FIN 44 (2000)
- Repairs and maintenance project
∽ 25 EITF issues
FASB 148 (2003)
- Transitional options for Companies
- Improved disclosures – interim reporting
Exposure Draft seeking harmonization with ED2 of the IASB – new
standard not likely expected until mid-2004
Stock-based Compensation
FASB Exposure Draft
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Expected this week (2/23)
Proposal is for a fair value model for public companies;
policy choice between fair value and intrinsic value –
variable for private companies
Eliminate minimum value method
Fair value model – preferred model is the Binomial
Lattice Model
February 2004
Stock-based Compensation
CICA Model – Section 3870 (2002)
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Mixed model, depends on award type:
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Non-exempt awards:
• SARs settleable with equity instruments - FV or intrinsic value
• All awards settleable with cash or other assets (includes SARs) Intrinsic value
• Direct awards of stock - Fair value
• ALL awards to non-employees - Fair value
Exempt awards: everything else
Be careful when reading the standard
-
February 2004
Written in a context that is inconsistent with the terminology used in US literature
Non-exempt and exempt distinction comes from the transitional provisions
Stock-based Compensation
CICA Model –Section 3870 (2002)
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Disclosure for exempt awards
- Pro forma net income and EPS
Effective January 1, 2002
 Certain awards “grandfathered”
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- Certain “exempt” awards
- Non-employee awards granted prior to the adoption date
February 2004
Stock-based Compensation
Section 3870 (2004)
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Full fair value model approved in 10/03
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Will be readdressed if IASB, FASB standards are different
Same transitional provisions as FAS 148
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Effective 1/1/04 for public; 1/1/05 for others
Retroactive (with or without restatement)
Prospective for awards not previously accounted for under fair value as long as adoption is
before 1/1/04
Also allows for harmonization for those who also report
under US GAAP
February 2004
Stock-based Compensation
IASB Exposure Draft (11/02)
Fair value at the grant date
 SAR’s and other instruments settleable in cash
and other assets are measured at fair value not
intrinsic value
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- Difference with existing Canadian and US GAAP
February 2004
Stock-based Compensation
IASB Exposure Draft (11/02)
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Other significant US GAAP and Canadian GAAP
differences
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February 2004
Non-employee awards – grant date
No exceptions for non-compensatory plans
Treatment of forfeitures – “up-front” versus as they happen
Settlements are not impacted immediately
FASB and CICA are monitoring deliberations (stated
view is to harmonize)
Stock-based Compensation
Plans to Consider
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Plain vanilla stock option
- Time vesting
- Performance vesting
SARs
 Non-employee arrangements
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February 2004
Stock-based Compensation
Plain Vanilla Stock Option
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February 2004
Date of grant: Jan. 1, 20X0
Market price at grant date: $10
Exercise price: $10
Fair value at grant date: $2
Vesting period: 100% at Dec. 31, 20X2
Expiration date: 5 yrs. from grant
Number of options granted:
100
EOY market prices: $12, $12, $17, $16, $24
EOY fair values: $3, $5, $7, $6, $14
Stock-based Compensation
G4+1 Model (7/00)
Fair Value—Vesting Date
YR 1
Fair value
YR 2
YR 3
YR 4
YR 5
$3
$5
$7
N/A
N/A
100
100
100
100
100
Cost
$300
$500
$700
N/A
N/A
% vested
33%
66%
100%
Aggregate
$99
$330
$700
Prior periods
-
99
330
Current cost
$99
$231
$370
# of Options
February 2004
Stock-based Compensation
US Model (APB 25)
Intrinsic Value—Measurement Date: Fixed Plan
YR 1
YR 2
YR 3
YR 4
YR 5
Intrinsic value
$0
N/A
N/A
N/A
N/A
# of Options
100
100
100
100
100
Cost
$ 0
$ 0
$ 0
N/A
N/A
% vested
33%
66%
100%
Aggregate
$ 0
$ 0
$ 0
Prior periods
-
0
0
Current cost
$ 0
$ 0
$ 0
February 2004
Stock-based Compensation
US Model (APB 25)
Intrinsic Value—Measurement Date: Variable Plan*
YR 1
YR 2
YR 3
YR 4
YR 5
Intrinsic value
$2
$2
$7
$6
$14
# of Options
100
100
100
100
100
Cost
$200
$200
$700
$600
$1,400
% vested
33%
66%
100%
100%
100%
Aggregate
$66
$132
$700
$600
$1,400
Prior periods
-
66
132
700
600
Current cost
$66
$66
$568
($100)
$800
February 2004
*Assumes 5year performance condition
Stock-based Compensation
US Model (FAS 123)
FV Value—Grant Date: Equity Instrument Award
YR 1
Fair value
YR 2
YR 3
YR 4
YR 5
$ 2
N/A
N/A
N/A
N/A
100
100
100
100
100
Cost
$200
$200
$200
N/A
N/A
% vested
33%
66%
100%
Aggregate
$66
$132
$200
Prior periods
-
66
132
Current cost
$66
$66
$68
February 2004
Rounding
Stock-based Compensation
CICA Model
Fair Value—Grant Date
YR 1
Fair value
YR 2
YR 3
YR 4
YR 5
$2
N/A
N/A
N/A
N/A
100
100
100
100
100
Cost
$200
$200
$200
N/A
N/A
% vested
33%
66%
100%
Aggregate
$66
$132
$200
Prior periods
-
66
132
Current cost
$66
$66
$68
# of Options
February 2004
Rounding
Stock-based Compensation
CICA Model
Opt Out Option
Dr
Cash
Cr
$1,000
Share capital
$1,000
To recognize receipt of cash upon exercise of stock option by employee
Opt out is not available under new Section 3870
February 2004
Stock-based Compensation
IASB Model (11/02)
YR 1
Fair value
YR 2
YR 3
YR 4
YR 5
$2
N/A
N/A
N/A
N/A
100
100
100
100
100
Cost
$200
$200
$200
N/A
N/A
% vested
33%
66%
100%
Aggregate
$66
$132
$200
Prior periods
-
66
132
Current cost
$66
$66
$68
# of Options
February 2004
Rounding
Stock-based Compensation
Summary—Plain Vanilla Option
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G4+1 (FV – both plans): $700
FASB (IV - fixed plan): $0
FASB (IV - variable plan): $1,400
FASB (FV - both plans): $200
CICA: (FV – both plans): $200
CICA (opt out): $0*
IASB (FV – both plans): $200
* No longer available under new Section 3870
February 2004
Stock-based Compensation
Stock Appreciation Rights
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Date of grant: Jan. 1, 20X0
Market price at grant date: $10
Exercise price: $10
Fair value at grant date: $2
Vesting period: 100% at Dec. 31, 20X2
Payout/Expiration date: 5 yrs. from grant
Number of options granted:
100
EOY market prices: $12, $12, $17, $16, $24
EOY fair values: $3, $5, $7, $6, $14
These are the same attributes as the Option example
February 2004
Stock-based Compensation
G4+1 Model (7/00)
Fair Value—Vesting Date
YR 1
YR 2
YR 3
YR 4
YR 5
Cash liability
$2
$2
$7
$6
$14
# of Options
100
100
100
100
100
Cost
$200
$200
$700
$600
$1,400
% vested
33%
66%
100%
100%
100%
Aggregate
$66
$132
$700
$600
$1,400
Prior periods
-
66
132
700
600
Current cost
$66
$66
$568
($100)
$800
February 2004
Stock-based Compensation
US Model (APB 25)
Intrinsic Value—Measurement Date: Variable Plan
YR 1
YR 2
YR 3
YR 4
YR 5
Cash Liability
$2
$2
$7
$6
$14
# of Options
100
100
100
100
100
Cost
$200
$200
$700
$600
$1,400
% vested
33%
66%
100%
100%
100%
Aggregate
$66
$132
$700
$600
$1,400
Prior periods
-
66
132
700
600
Current cost
$66
$66
$568
($100)
$800
February 2004
Stock-based Compensation
US Model (FAS 123)
FV (Intrinsic Value) —Liability Award
YR 1
YR 2
YR 3
YR 4
YR 5
Cash liability
$2
$2
$7
$6
$14
# of Options
100
100
100
100
100
Cost
$200
$200
$700
$600
$1,400
% vested
33%
66%
100%
100%
100%
Aggregate
$66
$132
$700
$600
$1,400
Prior periods
-
66
132
700
600
Current cost
$66
$66
$568
($100)
$800
February 2004
Stock-based Compensation
CICA Model
FV (Intrinsic Value) —Liability Award
YR 1
YR 2
YR 3
YR 4
YR 5
Cash liability
$2
$2
$7
$6
$14
# of Options
100
100
100
100
100
Cost
$200
$200
$700
$600
$1,400
% vested
33%
66%
100%
100%
100%
Aggregate
$66
$132
$700
$600
$1,400
Prior periods
-
66
132
700
600
Current cost
$66
$66
$568
($100)
$800
February 2004
Stock-based Compensation
IASB Model (11/02)
Fair Value
YR 1
Fair value
YR 2
YR 3
YR 4
YR 5
$3
$5
$7
$6
$14
100
100
100
100
100
Cost
$300
$500
$700
600
1,400
% vested
33%
66%
100%
100%
100%
Aggregate
$99
$330
$700
600
1,400
Prior periods
-
99
330
(700)
(600)
Current cost
$99
$231
$370
$(100)
$800
# of Options
February 2004
Stock-based Compensation
Summary—SARs
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
G4+1: $1,400
FASB: $1,400
CICA: $1,400
IASB: $1,400 (but note that the recognition pattern is
different)
Expected FASB exposure draft will lead to the same
answer as IASB
February 2004
Stock-based Compensation
CICA vs. FASB
Plan type
Plain vanilla
option
Cash SARs
3870
FV—grant date
Net equity SARs*
FV—grant date
OR
IV—variable
accounting
IV—variable
accounting
3870 opt out
**

N/A
N/A
APB 25
IV—fixed
accounting
IV-variable
accounting
SFAS 123
FV—grant date
IV—variable
accounting
FV—grant date
IV-variable
accounting
* Not previously discussed
** No longer available under new Section 3870
February 2004
Stock-based Compensation
Other Issues

Allocation period
Whose an employee?
 Forfeitures

- Expiry of options
February 2004

Modifications--repricing

Non-compensatory plans
Stock-based Compensation
Recognition of Compensation
Cost

If vesting: over the vesting period
-

Graded vesting vs. cliff vesting
-

February 2004
Choice depending on assumptions about expected life
Recognition given to forfeitures
-

No basis to argue for past services
Estimate or actual forfeitures
Expire unexercised ≠ forfeiture
Capitalize or expense cost
Stock-based Compensation
Repricing


IASB: re-measurement
FASB APB 25: re-measurement and variable accounting
until expire, exercise or forfeited
-


6 month look-back/look-forward
FASB SFAS 123: re-measurement
CICA: depends:
-
3870 Opt out: no accounting (again not available after effective
dates in new 3870)
3870: re-measurement
• No US/CAD GAAP difference: 3870 & SFAS 123
February 2004
Stock-based Compensation
Non-Employee Awards

FASB/CICA: fair value at measurement date:
- Earliest of:
• (1) performance commitment date,
• (2) performance completion date, or
• (3) grant date if fully vested non-forfeitable at that date
G4+1: fair value at the vesting date
 IASB: fair value at the grant date

February 2004
Stock-based Compensation
Who is an Employee

Under law
- Consistently represented as such


Directors for director services
Leased employees
- Microsoft phenomenon
- Need to participate in benefits
February 2004
Stock-based Compensation
Measurement Date

Probable supplier will perform
-

Sufficiently large disincentive for nonperformance
• Excludes: forfeiture of equity instruments or risk of being sued
• Would continue to perform even though grant worthless
• Unlikely anyone would agree to such a penalty
Matter of judgment
Result: measure at performance completion date
-
February 2004
Estimate cost of goods/service in interim periods: variable
accounting
Stock-based Compensation
Non-Employee Award
1,000 options for consulting services
 Performance period: 1 year
 FVs at EOQ: $10, $8, $14, $20
 Assume no forfeitures

February 2004
Stock-based Compensation
Cost of Consulting Services
1’Q
2’Q
3’Q
4’Q
Fair value
$10
$8
$14
$20
Options
1,000
1,000
1,000
1,000
$10,000*
$8,000
$14,000
$20,000
25%
50%
75%
100%
$2,500
$4,000
$10,500
$20,000
-
$2,500
$4,000
$10,500
$2,500
$1,500
$6,500
$9,500
% complete
Accrual
Prior period
Current period
February 2004
*if fully vested non-forfeitable
Stock-based Compensation
Investors’ Concerns

Information usefulness
-


Dilution/overhang
Need for shareholder approval
-

Who wants to be an optionnaire???
Circumvent by repurchase shares in market
Repricing
-
non-employee shareholders lose when price falls
6 month rule—anti-motivational:
• want share price to fall in the interim
February 2004
Stock-based Compensation
Nightmare on Dilution Street*
% growth Jan., 1998, through Oct., 2001
Nortel
Cisco
Sales growth
14%
104%
Sales per share growth
- 26%
76%
Celestica
222%
6%
Lucent
- 40%
- 53%
JDS Uniphase
586%
81%
*Globe and Mail
February 2004
Stock-based Compensation
Financial Engineering

Intrinsic value method:
- Zero intrinsic value plans
- No performance conditions other than time vesting

Non-employee plans:
- Fully vested non-forfeitable
• Economic reality???
February 2004
Stock-based Compensation
Questions?