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Strategic Accounting
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Share-Based Payment
Note: This reading is based on IFRS 2, ―Share-Based Payment,‖ which is
largely convergent with SFAS 123 (R), ―Share-Based Payment.‖
Many compensation plans include one or more types of share-based awards.
These include outright awards of shares, stock options, or cash payments tied to
the market price of shares. Usually, an executive compensation plan is tied to
performance in a way that uses compensation to motivate its recipients.
Regardless of the form such a plan takes, the accounting objective is to record
the fair value of the compensation expense over the periods in which related
services are performed. That means we need to (a) determine the fair value of
the compensation and (b) expense that compensation over the periods in which
participants perform services.
Stock Award Plans
Sometimes the compensation is a grant of shares of stock. In that case, the
shares usually are restricted in a way that benefits are tied to continued
employment. Shares usually are subject to forfeiture by the employee if
employment is terminated within some specified number of years from the date
of grant and the employee cannot sell the shares during the restriction period.
The compensation is the market price of unrestricted shares of the same stock
and is accrued as compensation expense over the service period for which
participants receive the shares. This usually is the period from the date of grant
to when restrictions are lifted (the vesting date).
Illustration
Under its restricted stock award plan, Ford Storage grants 6 million of its $1
par common shares to division managers at January 1, 2011. The shares are
subject to forfeiture if managers leave the company within three years. Shares
have a current market price of $15 per share.
Total compensation:
$15 fair value per share
x 6 million shares awarded
= $90 million total compensation
The total compensation is to be allocated to expense over the 3-year service
(vesting) period: 2011 - 2012
$90 million ÷ 3 years = $30 million per year
December 31, 2011, 2012, 2013 ($ in millions)
Compensation expense ($90 million ÷ 3 years) 30
Paid-in capital – restricted stock 30
December 31, 2013
Paid-in capital – restricted stock (6 million shares at $15) 90
Common stock (6 million shares at $1 par) 6
Paid-in capital – excess of par (to balance) 84
If restricted stock is forfeited because, say, the employee quits the company,
related entries previously made would simply be reversed.
Stock Option Plans
Stock option plans give recipients the option to purchase (a) a specified number
of shares of the firm's stock, (b) at a specified price, (c) during a specified period
of time. Again, the accounting objective is to report compensation expense at
the fair value of the options during the period of service for which the
compensation is given.
Voluntary Expensing. Prior to 2007, only two companies—Boeing and Winn-
Dixie—reported stock option compensation expense at fair value. However, in
2007 public outrage mounted amid high-profile accounting scandals at Enron,
WorldCom, Tyco, and others. Some degree of consensus emerged that greed on
the part of some corporate executives contributed to the fraudulent and
misleading financial reporting at the time. In fact, many in the media were
pointing to the proliferation of stock options as a primary form of compensation
as a culprit in fueling that greed. An episode of the PBS series Frontline argued
that not expensing the value of stock options contributed to the collapse of
Nearly 500 U.S. Enron. For these reasons, renewed interest surfaced in requiring stock option
companies voluntarily compensation to be reported in income statements. At least partly in response to
reported the fair value of this public sentiment, Coca-Cola announced in 2007 that it would begin
stock options as an reporting the fair value of its stock options as an expense. Perhaps seeing the
expense.
―writing on the wall,‖ other companies soon followed suit. By the end of 2009,
nearly 500 firms were voluntarily expensing options.
Current Requirement to Expense. Emerging from the rekindled debate was
an FASB Standard that now requires fair value accounting for employee stock
An FASB Standard now options, eliminating altogether the intrinsic value approach. As you might
compels companies to expect, the proposal did not come without opposition. Many of the same groups
record the value of that successfully blocked the FASB from enacting a similar requirement in 1995
options in their income led the opposition. Not surprisingly, at the forefront of the resistance were the
statements. high-tech companies that extensively use stock options as a primary form of
compensating employees and thus are most susceptible to a reduction in
reported earnings when that compensation is included in income statements.
Mandatory expensing of
For illustration, consider Apple Computer’s earnings for the 12 months ending
stock options generally
causes lower net income,
March 27, 2009. Reported net income of $179 million would have been only
but the effect varies from $56 million, or 69% less, if the Standard had been in effect then.
company to company. It’s important to note that the way we account for stock options has no effect
whatsoever on cash flows, only on whether the value of stock options is
included among expenses. This is not to say that companies haven’t altered
We’ve witnessed a their compensation strategies. Already, we have seen a shift in the way some
discernable shift in the companies compensate their employees. Partly due to the negative connotation
way executives are that has become associated with executive stock options and partly due to the
compensated – fewer
stock market decline of recent years that caused millions of options to become
options, more stock
awards and bonuses. worthless, we’ve seen fewer options and more bonuses and restricted stock
awards. For its fiscal year ending June 30, 2009, for instance, technology
company JDS Uniphase awarded stock options to employees worth only 11% of
the $1.25 billion value of its 2006options. Now let’s examine the way stock
options are accounted for now.
Fair value is estimated at the grant date using an option-pricing model that
considers the exercise price and expected term of the option, the current market
price of the underlying stock and its expected volatility, expected dividends, and
the expected risk-free rate of return.
Illustration
Under its executive stock option plan, Ford Storage grants options at January
1, 2011, that permit division managers to acquire 10 million of the company’s
$1 par common shares within the next 7 years, but not before December 31,
2014 (the vesting date). The exercise price is the market price of the shares on
the date of grant, $15 per share. The fair value of the options, estimated by an
appropriate option pricing model, is $8 per option.
Total compensation:
$8 estimated fair value per option
x 10 million options granted
= $80 million total compensation
The total compensation is to be allocated to expense over the 4-year service
(vesting) period, 2011 – 2014:
$80 million ÷ 4 years = $20 million per year
December 31, 2011, 2012, 2013, 2014 ($ in millions)
Compensation expense ($80 million ÷ 4 years) 20
Paid-in capital – stock options ........ 20
What if Ford Storage estimated a 5% forfeiture rate? In that case, annual
compensation expense would have been $19 million ($80 x 95% / 4) instead of
$20 million.
What if that expectation changes later? Ford Storage should adjust the
cumulative amount of compensation expense recorded to date in the year the
estimate changes. Suppose, for instance, that during 2013, the third year, Ford
Storage revises its estimate of forfeitures from 5% to 10%. The new estimate of
total compensation would then be $80 million x 90%, or $72 million. For the
first three years, the portion of the total compensation that should have been
reported would be $72 million x ¾, or $54 million, and since $38 million ($19 x
2) of that was recorded in 2011-2012 before the estimate changed, an additional
$16 million would now be recorded in 2013. Then if the estimate isn’t changed
again, the remaining $18 million ($72 – 54) would be recorded in 2014.
2011 ($ in millions)
Compensation expense ($80 x 95% / 4) ..................... 19
The value of the Paid-in capital –stock options ............................. 19
compensation is estimated
to be $76 million, or $19
million per year.
2012
Compensation expense ($80 x 95% / 4) ..................... 19
Paid-in capital –stock options ............................. 19
2013
The expense each year is the
Compensation expense ([$80 x 90% x ¾] – [$19 + 19]) 16
current estimate of total
compensation that should Paid-in capital –stock options ............................. 16
have been recorded to date
less the amount already 2014
recorded. Compensation expense ([$80 x 90% x 4/4] – [$19 + 19 + 16]) 18
Paid-in capital –stock options ............................. 18
Notice that the $18 million is the amount that would have been reported in each
of the four years if Ford Storage had assumed a 10% forfeiture rate from the
beginning. Also be aware that this approach is contrary to the usual way
companies account for changes in estimates. For instance, assume a company
acquires a 4-year depreciable asset having an estimated residual value of 5% of
cost. The $76 million depreciable cost would be depreciated straight-line at $19
million over the four-year useful life. If the estimated residual value changes
after two years to 10%, the new estimated depreciable cost of $72 would be
reduced by the $38 million depreciation recorded the first two years, and the
remaining $34 million would be depreciated equally, $17 million per year, over
the remaining two years.
Incentive vs. Nonqualified Plans. For tax purposes, plans can either qualify as
an ―incentive stock option plan‖ under the Tax Code or be "unqualified plans."
Among the requirements of a qualified option plan is that the exercise price be
equal to the market price at the grant date. Under a qualified incentive plan,
the recipient pays no income tax until any shares acquired are subsequently sold.
On the other hand, the company gets no tax deduction at all. With a
nonqualified plan the employee can’t delay paying income tax, but the
employer is permitted to deduct the difference between the exercise price and
the market price at the exercise date.
U.S. GAAP VS. IFRS
Recognition of Deferred Tax Asset for Stock Options. Under U.S. GAAP, a deferred tax asset (DTA) is
created for the cumulative amount of the fair value of the options the company has recorded for
compensation expense. The DTA is the tax rate times the amount of compensation.
Under IFRS, the deferred tax asset isn’t created until the award is “in the money;” that is, it has
intrinsic value. When it is in the money, the addition to the DTA is the portion of the intrinsic value
earned to date times the tax rate.
For example, refer to our option illustration and assume the plan does not qualify as an incentive
plan. Now assume the share price, which was equal to the $35 exercise price on January 1, 2011, was
$35, $37, $37, and $37.50 on December 31, 2011, 2012, 2013, and 2014, respectively. We need this
information to determine the intrinsic value for IFRS.
The addition to the DTA and reduction in the tax expense (tax benefit) is calculated in the
following table for both U.S. GAAP and IFRS ($ in millions):
Addition to Intrinsic Addition to
DTA and Cumulative value Percent Percent DTA and
Compen reduction in reduction (price – $35) of x reduction in
-sation tax expense in tax x 10M services Intrinsic tax expense
Dec. expense at 40% expense shares received value at 40%*
31 U.S. GAAP IFRS
2011 $20 $ 8 $ 8 $ 0 25% $ 0 $ 0
2012 20 8 16 20 50% 10 4
2013 20 8 24 20 75% 15 6
2014 20 8 32 25 100% 25 10
December 31, 2011, 2012, 2013, 2014 ($ in millions) U.S. GAAP IFRS
Compensation expense ($80 million 4 years) 20 20
Paid-in capital—stock options 20 20
Deferred tax asset 8 0
Income tax expense 8 0
Deferred tax asset 8 4
Income tax expense 8 4
Deferred tax asset 8 6
Income tax expense 8 6
Deferred tax asset 8 10
Income tax expense 8 10
* The tax benefit recorded in earnings (cumulative amount in this column) cannot exceed the cumulative
tax effect of the compensation (4th column). Any tax benefit in excess of that amount is recorded in
equity. In 2014, $20($0+4+6+10) does not exceed $32.
Decline in Popularity of Options. Recent years In today's world, stock options
have witnessed a steady shift in the way are still important, but other
companies compensate their top executives. In equity compensation plans are
the wake of recent accounting scandals, the image rapidly assuming greatersuch as
importance. Companies
of stock options has been tarnished in the view of Amazon.com and Microsoft are
many who believe that the potential to garner moving from stock options to
restricted stock.
millions in stock option gains created incentives
for executives to boost company stock prices - "Beyond Stock Options,"
through risky or fraudulent behavior. That image National Center for Employee
Ownership, 5th ed. (February 2012).
has motivated many firms to move away from
stock options in favor of other forms of share-
based compensation, particularly restricted stock
awards. Also contributing to the rise of restricted stock is the feeling by many
that it better aligns pay with performance. As of 2013, the value of restricted
stock awards given to top executives had surpassed the value of stock options
awarded.
PLANS WITH GRADED-VESTING
The stock option plans we’ve discussed so far vest (become exercisable) on one
single date (e.g., four years from date of grant). This is referred to as ―cliff
vesting.‖ More frequently, though, awards specify that recipients gradually
become eligible to exercise their options rather than all at once. This is called
―graded vesting.‖ For instance, a company might award stock options that vest
25% the first year, 25% the second year, and 50% the third year, or maybe 25%
each year for four years.
In such a case, the company can choose to account for the options essentially
the same as the cliff-vesting plans we’ve discussed to this point. It can estimate
a single fair value for each of the options, even though they vest over different
time periods, using a single weighted-average expected life of the options. The
company then allocates that total compensation cost (fair value per option times
number of options) over the entire vesting period.
Most companies, though, choose a slightly more complex method because it
usually results in a lower expense.11 In this approach, we view each vesting
group (or tranche) separately, as if it were a separate award.
Illustration Taggart Mobility issued 10 million executive stock options permitting
Stock options; graded executives to buy 10 million shares of stock for $25. The vesting schedule is
vesting; separate 20% the first year, 30% the second year, and 50% the third year (graded-
valuation approach vesting). The value of the options that vest over the 3-year period is estimated
at January 1, 2011, by separating the total award into three groups (or tranches)
according to the year in which they vest (because the expected life for each
group differs). The fair value of the options is estimated as follows:
11The fair value of the options usually is higher when estimated using a single
weighted-average expected life of the options rather than when estimated as the total
of fair values of the multiple vesting groups.
Vesting Amount Fair Value
Date Vesting per Option
Dec. 31, 2011 20% $3.50
Dec. 31, 2012 30% $4.00
Dec. 31, 2013 50% $6.00
The compensation expense related to the options to be recorded each year 2011-
2013 is:
Vesting Amount Fair Value Compensation
Date Vesting per Option Cost
(shares in millions) ($ in millions)
Dec. 31, 2011 2 $3.50 $ 7
Dec. 31, 2012 3 $4.00 12
Dec. 31, 2013 5 $6.00 30
$49
We allocate the compensation cost for each of the three groups (tranches)
evenly over its individual vesting (service) period:
Shares Compensation Expense Recorded in: ($ in millions)
Vesting at: 2011 2012 2013 Total
Dec. 31, 2011 $ 7 $ 7
Dec. 31, 2012 6 $ 6 12
Dec. 31, 2013 10 10 $10 30
$23 $16 $10 = $49
At any given date, a company must have recognized at least the amount
vested by that date. The allocation in this instance meets that constraint:
The $23 million recognized in 2011 exceeds the $7 million vested.
The $39 million ($23 + $16) recognized by 2012 exceeds the $19 million
($7 + $12) vested by the same time.
Companies also can choose to use the straight-line method, which would
allocate the $49 million total compensation cost equally to 2011, 2012, and
2013 at $16,333,333 per year.
U.S. GAAP / IFRS Difference
When options have graded-vesting, U.S. GAAP permits companies to account
for each vesting amount separately, for instance as if there were three separate
awards in the previous illustration, but also allows companies the option to
account for the entire award on straight-line basis over the entire vesting period.
Either way, the company must recognize at least the amount of the award that
has vested by that date.
Under IFRS, the straight-line choice is not permitted. Also, there’s no
requirement that the company must recognize at least the amount of the award
that has vested by each reporting date.
PLANS WITH PERFORMANCE OR MARKET CONDITIONS
Stock option (and other share-based) plans often specify a performance
condition or a market condition that must be satisfied before employees are
allowed the benefits of the award. The objective is to provide employees with
additional incentive for managerial achievement. For instance, an option may
not be exercisable until a performance target is met. The target might be
divisional revenue, earnings per share, sales growth, or rate of return on assets.
The possibilities are limitless. On the other hand, the target might be market-
related, perhaps a specified stock price or stock price changes exceeding a
particular index. The way we account for such plans depends on whether the
condition is performance-based or market-based.
Decline in Popularity of Options. Recent years In today's world, stock options
have witnessed a steady shift in the way are still important, but other
companies compensate their top executives. In equity compensation plans are
rapidly assuming greater
the wake of recent accounting scandals, the image importance. Companies such as
of stock options has been tarnished in the view of Amazon.com and Microsoft are
many who believe that the potential to garner moving from stock options to
restricted stock.
millions in stock option gains created incentives
for executives to boost company stock prices - "Beyond Stock Options,"
National Center for Employee
through risky or fraudulent behavior. That image Ownership, 5th ed. (February 2012).
has motivated many firms to move away from
stock options in favor of other forms of share-
based compensation, particularly restricted stock
awards. Also contributing to the rise of restricted stock is the feeling by many
that it better aligns pay with performance. As of 2013, the value of restricted
stock awards given to top executives had surpassed the value of stock options
awarded.
Plans with Performance Conditions. Whether we recognize compensation
expense for performance-based options depends (a) initially on whether it’s
probable that the performance target will be met and (b) ultimately on whether
the performance target actually is met. Accounting is as described earlier for
other stock options. Initial estimates of compensation cost as well as
subsequent revisions of that estimate take into account the likelihood of both
If compensation from a
stock option depends on
forfeitures and achieving performance targets. For example, if options included
meeting a performance a condition that the options would become exercisable only if sales increase by
target, then whether we 10% after four years, we would estimate the likelihood of that occurring;
record compensation specifically, is it probable? Let’s say we initially estimate that it is probable that
depends on whether or not sales will increase by 10% after four years. Then, our initial estimate of the
we feel it’s probable the
target will be met. total compensation would have been unchanged at:
10 million x $8 = $80 million
options fair estimated
expected value total
to vest compensation
Suppose, though, that after two years, we estimate that it is not probable that
sales will increase by 10% after four years. Then, our new estimate of the total
compensation would change to:
0 x $8 = $0
If it later becomes probable options fair estimated
that a performance target expected value total
will not be met, we reverse to vest compensation
any compensation expense
already recorded.
In that case, we would reverse the $40 million expensed in 2011-2012
because no compensation can be recognized for options that don’t vest due to
performance targets not being met, and that’s our expectation.
Conversely, assume that our initial expectation is that it is not probable that
sales will increase by 10% after four years and so we record no annual
When we revise our
estimate of total compensation expense. But then, after two years, we estimate that it is probable
compensation because our that sales will increase by 10% after four years. At that point, our revised
expectation of probability estimate of the total compensation would change to $80 million, and we would
changes, we record the reflect the cumulative effect on compensation in 2013 earnings and record
effect of the change in the
compensation thereafter:
current period.
If we had begun with our
new estimate of total 2013
compensation, $60 million Compensation expense ([$80 x ¾] - $0) ..................... 60
would have been expensed Paid-in capital –stock options ............................. 60
in the first three years.
2014
This leaves $20 million to
be expensed the fourth year. Compensation expense ([$80 x 4/4] - $60) .................. 20
Paid-in capital –stock options ............................. 20
Plans with Market Conditions. If the award contains a market condition (e.g.,
If the target is based on
changes in the market rather a share option with an exercisability requirement based on the stock price
than on performance, we reaching a specified level), then no special accounting is required. The fair
record compensation as if value estimate of the share option already implicitly reflects market conditions
there were no target.
due to the nature of share option pricing models. So, we recognize
compensation expense regardless of when, if ever, the market condition is met.
Employee share purchase plans
Employee share purchase plans allow employees to buy company stock
under convenient or favorable terms. Most such plans are considered
compensatory and require the fair value of any discount to be recorded as
compensation expense. If the discount to employees is 15%, for instance, the
discount is considered to be compensation and that amount is recorded as
expense. Say an employee buys shares (no par) under the plan for $850 rather
than the current market price of $1,000. The $150 discount is recorded as
compensation expense:
Cash (discounted price) ................................................. 850
Compensation expense ($1,000 x 15%) ......................... 150
Common stock (market value) ................................. 1,000
