Session 802: FAS123R

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Session 802 FAS123R

• Enrolled Actuaries Meeting
• March 28, 2007

Stacy Powell, FSA Vice President
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Table of Contents

• Cost, benefit, and value
• Stock-based compensation A different animal
• Option valuation
• SFAS 123R
• Why expense stock options?
• Evolution of stock-based compensation accounting
• FAS 123R expense development
• Deferred Tax Accounting
• Diluted earnings per share impact
• Modifications of equity awards
• Current events
• QA

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Stock-Based Compensation Defined

• SFAS 123R definition
• Company stock provided to employees or
  nonemployees in exchange for goods or services
• Typical stock option plan design
• Strike price Grant date stock price
• Service-based vesting provision
• 25 per year over 4 years (graded vesting)
• 100 after 3 years (cliff vesting)
• Special provisions for termination, retirement,
  etc.
• Restricted stock is another common vehicle
• Compensatory Employee Stock Purchase Plans
  (ESPPs)
• Performance shares are gaining popularity
• Performance Conditions (internal performance
  metrics)
• Market Conditions (stock price)

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Stock-Based Compensation Benefit, Cost, and
Value
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Why Expense Stock Options?

• Why not? Common arguments
• Value is impossible to measure accurately
• Factored in to EPS dilution already
• Detrimental to start-ups and technology firms
• Non-cash expense
• Valuable form of compensation
• Costly to investors

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Option Valuation

• Value Intrinsic Value Time Value
• Intrinsic Value Stock Price Strike Price
• Time Value PV of expected additional gain
• Determination of time value
• Magnitude of gain Stock price forecast
• Timing of gain Expected exercise behavior
• Discount rate

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Option Valuation

• SFAS 123R requirements
• Discussed much more rigorously in Track 7 of this
  Conference (see Stacy Powell for handouts)
• Assumptions reasonably reflect a basis on which
  the award would be exchanged
• Model is based on financial economic theory and
  generally applied in that field
• Valuation reflects substantive characteristics of
  the plan
• Generally accepted models
• Black-Scholes formulas
• Cox Ross Rubinstein Binomial Model (CRR)
• Hull-White Binomial Models
• Custom Binomial Models
• Monte Carlo simulation

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Evolution of Stock-Based Compensation Accounting
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SFAS 123R Expensing Basics
Grant Date Fair Value (GDFV)
Number of Awards Expected to Vest
Expected Total Compensation Cost
X

True-up over time with vesting experience
Generally not trued up to settlement value
Attribute cost over the vesting period

• Ultimate expense GDFV x Vested Awards
• Cumulative expense gt GDFV of vested awards
• Expense accrued over vesting period

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SFAS 123R Expense Recognition

• Sample Award Characteristics
• Grant Date 1/1/2006
• Options Granted 1,000,000
• Vesting Schedule 4 years, 25 per year
• Grant-Date Stock Price/Exercise Price 30
• Grant-Date Fair Value, Per Option 10
• Total Grant-Date Fair Value 10,000,000

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SFAS 123R Expense Recognition

• Attribute 10,000,000 over 4 years
• Straight-line (service-based vesting only)
• 2,500,000 per year
• Accelerated under FIN 28 (each tranche as if
  separate award)
• Forfeiture assumption must be made, and trued up
  over time best practice is to reconcile each
  interim period

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Deferred Tax Accounting

• A future tax deduction is expected
• Proxy for future tax deduction is fair value
• Deferred tax asset (DTA) is accumulated as
  expense is recognized
• Only for non-qualified structures
• Actual tax benefit compared to DTA
• Windfall Save it to cover future shortfalls
• Shortfall Net against windfall pool, or Current
  Tax Expense

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Deferred Tax Accounting

• Continuation of example
• Accumulated DTA of 3,500,000 over 4 years
  (10,000,000 X 35 Tax Rate)
• Tax accounting upon exercise

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The APIC/Windfall Pool
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Diluted Earnings Per Share
Numerator is reduced by FAS 123R Expense
Income Available to Shareholders Common and
Dilutive Shares
Denominator includes employee stock options
outstanding
ARE WE DOUBLE-COUNTING THE IMPACT OF STOCK
OPTIONS ON EPS?
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Diluted EPS Treasury Stock Method
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FAS123R Modifications

• Modifications are far more common now
• A modification of an award is treated as an
  exchange of the original award for a new award
• Requires valuation immediately before the
  modification, and immediately after the
  modification
• Examples of Plan Modifications
• Acceleration of vesting due to a termination
  (EXAMPLE)
• Extension of Exercisable Period
• Knowledge of an upcoming terminating event
• Absent knowledge of a terminating event
• Upward Repricing (currently common due to
  backdating) (EXAMPLE)
• Downward Repricings
• Exchange of Awards in a business combination/
  FAS141 (EXAMPLE)
• Modification in connection with an equity
  restructuring (spin-off, stock split, or one-time
  dividend payout)

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Example of ModificationAcceleration of Vesting
Accounting for Modifications

• Example
• At-the-money options that cliff-vest in five
  years are granted on January 1, 2007 when the
  market price of the companys stock is 30
• Three years after the grant date, when the market
  price of the companys stock is 45, the company
  modifies the options to immediately accelerate
  vesting
• Valuation challenges for selecting exercise
  behavior for non-ATM options

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Example of ModificationAcceleration of Vesting
(continued)

• Acceleration of vesting due to a termination
• Type 3 modification (Improbable to Probable)
• Immediately before 28.74 times 0 expected to
  vest
• Immediately after 24.98 times 100 expected to
  vest
• Therefore, incremental expense equal to 24.98

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Example of ModificationUpward Repricing
Accounting for Modifications

• Example
• Discounted stock options face punitive tax
  consequences under IRC Section 409A
• In many backdating cases, companies are repricing
  the strike price upwards and also providing
  additional cash payments of the increased strike
  price to compensate for the increase
• 100 options granted on 1/1/2007 that cliff vest
  on 1/1/2009 with an exercise price of 10
• The grant date fair value is 6, therefore a
  total of 600 of compensation expense should be
  amortized from 1/1/2007 to 1/1/2009
• The exercise price is upwardly repriced to 13 on
  7/1/2007 and a cash payment of 300 is provided.
  The market price is 20 on 7/1/2007

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Example of ModificationUpward Repricing
(continued)

• Incremental fair value of 200 (2 x 100). Since
  vested, the full 200 is recognized immediately.
• The remaining 100 cash payment (300 cash
  payment less 200 incremental value) is
  effectively a cash settlement. Because the
  options were non-vested, the settlement
  accelerates recognition of compensation cost for
  the portion that was settled.
• Settlement Ratio determined by dividing 100 by
  the value immediately before the modification of
  1300, or approximately 7.7.
• Prior to modification, 150 of compensation
  expense was recognized, 6/24 months have been
  recognized out of the total 600 of expense.
  Therefore, 450 remains to be recognized.
• Based on settlement ratio of 7.7, 35 of
  compensation cost needs to be accelerated
• Remaining compensation cost of 415 (450-35)
  should be recognized over remaining 18 month
  service period

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Example of ModificationBusiness Combinations
and Converted Awards
Accounting for Modifications

• Example
• Company A purchases Company B and converts
  Company B awards into Company A awards on
  1/1/2007
• Company A has maintained the same terms and
  conditions (2.5 years remaining on 4 year graded
  vesting and 8.5 years remaining to expiration)
  for the converted awards as the original Company
  B awards (originally 4 year vesting and 10 year
  term on 7/1/2005)
• Company A maintains the same intrinsic value
  (keeps employees whole), and maintains the same
  ratio of Market Price / Strike Price (per FIN44)
• Considered a modification and requires valuation
  immediately before and immediately after
• Valuation of vested awards goes into Purchase
  Price
• Valuation of non-vested awards required to be
  amortized over remaining vesting period

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Example of ModificationBusiness Combinations
and Converted Awards
Accounting for Modifications

• Example
• Original grant date value on 7/1/2005 of 5, for
  500 of total compensation expense
• Significant valuation challenges in picking
  exercise behavior immediately before and after
  the modification, since awards are not ATM, and
  all have varying degrees of remaining vesting and
  contractual term
• SAB 107 simplified approach
• Computed Expected Life from IRS Revenue Procedure
  98-34
• More sophisticated Monte Carlo simulation and
  hazard modeling
• As of 1/1/2007, valuation immediately after the
  conversion, fair value equal to 30
• Since 25 (12 options) of the awards are vested,
  360 (12 x 30) is recognized as part of the
  Purchase Price
• The remaining 75 of options (38 options) are
  nonvested, 1,140 (38 x 30) should be amortized
  over the remaining service period (30 months).
  Therefore, 456 should be recognized during 2007.

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Navigating Footnote Disclosures

• Information can usually be found in
• Summary of Accounting Policies footnote
• Stock Compensation footnote
• Required annual disclosure
• Share roll-forward, aggregate intrinsic value
• FAS 123R Impact on Net Income and EPS
• Valuation methodology and assumptions

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Impact of Expensing Stock Options

• No form of equity compensation is free
• Plain vanilla stock options are no longer favored
• Performance-based features no longer penalized
• Enhanced 10K and proxy disclosure
• Clearer picture of equity compensation programs
• Enhances investors and analysts ability to
  forecast dilution
• Convergence to international accounting standards

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Current Events

• Option granting practices
• Backdating (Over 100 companies being
  investigated)
• Google Transferable Stock Options
• SEC Proxy Disclosure of Executive Comp
• Zions Bank Market-Based Valuation

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QA