Chapter 19:

Share-Based Compensation
ASC 718 (SFAS 123R)

Learning Objectives
1.
2.
3.
4.

19 - 1

Accounting for stock award plans.

Accounting for stock options.
Accounting for employee share purchase plans.
Simple and a complex capital structure.

Share-Based Compensation
Form of compensation in which the amount of the
compensation employees receive is tied to the
market price of company stock.
An executive compensation plan is tied
to performance in a strategy that uses
compensation to motivate it recipients.
These share-based compensation plans
stock awards,
-stock options, and
-stock appreciation rights,
create shareholders equity.
The nature of this compensation will impact
the way earnings per share is calculated.
19 - 2

Share-Based Compensation
Whichever form such a plan assumes, the
accounting objective is to record the fair value
of compensation expense over the periods in
which related services are performed.
This requires:
1. Determining the fair value of the compensation.
2. Expensing that compensation over the
periods in which participants perform services.

19 - 3

Stock Award Plans

FEATURES:
The compensation is a grant of shares of stock.
-The shares usually are restricted (non-vested) so that
benefits are tied to continued employment.
-Usually shares are subject to forfeiture if employment is
terminated within some specified number of years from the
date of grant.
-The employee cannot sell the shares during the restriction
period. => Between GRANT Date and VESTING Date.

19 - 4

Stock Award Plans

Compensation is a grant of shares of stock.
-The compensation is simply the market price of the stock
at the grant date.
-Compensation is accrued as expense over the service
period for which participants receive the shares.
-The service period usually is the period from the date of
grant to when restrictions are lifted (the vesting date).
-If restricted stock is forfeited, related entries previously
made would simply be reversed.

19 - 5

STOCK AWARD PLANS ILLUSTRATION

Under its restricted stock award plan, Universal Communications grants
5 million of its $1 par common shares to certain key executives at
January 1, 2011. The shares are subject to forfeiture if employment is
terminated within 4 years. Shares have a current price of $12 per share.
January 1, 2011
No entry
Calculate total compensation expense:
$12
Fair value per share
x
5 million
Shares awarded
=
$60 million
Total compensation
The total compensation is allocated to expense over the 4-year service
(vesting) period: 2011 2014 as follows:
$60 million 4 years = $15 million per year
19 - 6

STOCK AWARD PLANS ILLUSTRATION

Journal Entries:
December 31, 2011, 2012, 2013, 2014 ($ in millions):
Compensation expense ($60 million 4 years)
Paid-in capital restricted stock
December 31, 2014 (On Vesting Date):
Paid-in capital restricted stock (5 million sh. at $12)
Common stock (5 million shares at $1 par)
Paid-in capital excess of par (to balance)

15
15
60

If restricted stock is forfeited because, say, the employee quits the

company, related entries previously made would simply be reversed.

19 - 7

5
55

STOCK AWARD PLANS

Exercise 19-1
Exercise 19-2
Exercise 19-4

19 - 8

Stock Option Plans

Stock option plans give employees the option to buy
(a) a specified number of shares of the firm's stock,
(b) at a specified exercise price,
(c) during a specified period of time.
The fair value is accrued as compensation expense
over the service period for which participants receive
the options, usually from the date of grant to when
the options become exercisable (the vesting date).

19 - 9

Expense The Great Debate

Historically, options have been measured at
their intrinsic value the simple difference
between the market price of the shares and
the option price at which they can be
acquired.
If the market and exercise price are equal on
the date of grant, no compensation expense
is recognized even if the options provide
executives with substantial income.

19 - 10

Failed Attempt to Require Expensing

Opposition
Opposition to
to aa proposed
proposed FASB
FASB Statement
Statement to
to
recognize
recognize expense
expense for
for certain
certain stock
stock option
option
plans
plans have
have identified
identified three
three objections.
objections.
1.
1. Options
Options with
with no
no intrinsic
intrinsic value
value at
at issue
issue
have
have zero
zero fair
fair value
value and
and should
should not
not give
give
rise
rise to
to expense
expense recognition.
recognition.
2.
2. ItIt is
is impossible
impossible to
to measure
measure the
the fair
fair value
value
of
of compensation
compensation on
on the
the date
date of
of grant.
grant.
3.
3. Current
Current practices
practices have
have unacceptable
unacceptable
economic
economic consequences.
consequences.
19 - 11

Recognizing Fair Value of Options

Accounting
Accounting for
for stock
stock options
options parallels
parallels the
the accounting
accounting
for
for restricted
restricted stock
stock we
we discussed
discussed earlier.
earlier.
We
We now
now are
are rrequired
equired to
to estimate
estimate the
the fair
fair value
value of
of
stock
stock option
option on
on the
the grant
grant date.
date.
The FASB now requires that compensation expense be
measured using one of several option pricing models
that deal with:
1. Exercise price of the option.
2. Expected term of the option.
3. Current market price of the stock.
4. Expected dividends.
5. Expected risk-free rate of return.
6. Expected volatility of the stock.
19 - 12

EXPENSING STOCK OPTIONS

At January 1, 2011, Universal Communications grants
options that permit key executives to acquire 10 million of
the companys $1 par common shares within the next 8
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, $35 per share. The fair value
of the options, estimated by an appropriate option-pricing
model, is $8 per option.
January 1, 2011
No entry
Calculate total compensation expense:
$8
estimated fair value per option
x 10 million
options granted
= $80 million
total compensation

19 - 13

EXPENSING STOCK OPTIONS

At January 1, 2011, Universal Communications grants options that permit
key executives to acquire 10 million of the companys $1 par common shares
within the next 8 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, $35
per share. The fair value of the options, estimated by an appropriate optionpricing model, is $8 per option.
The total compensation is 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

19 - 14

EXPENSING STOCK OPTIONS

ESTIMATED FORFEITURES

If a forfeiture rate of 5% was expected, annual compensation

expense would have been $19 million ($76 / 4) instead of $20
million.

During 2013, the third year, Universal 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.

The expense each year is the current estimate of total

compensation that should have been recorded to date
less the amount already recorded.
3rd Year = $16M = ($80 million x 90% x ) [$19 + 19])
4th Year = $18M = ([$80 million x 90% x 4/4] [$19 + 19 + 16])

19 - 15

EXPENSING STOCK OPTIONS

ESTIMATED FORFEITURES
2011
($ in millions)
Compensation expense ($80 x 95% x 1/4)
Paid-in capital stock options
2012
Compensation expense ($80 x 95% x 1/4)
Paid-in capital stock options
2013
Compensation expense ([$80 x 90% x ] [$19 + 19])
Paid-in capital stock options
2014
Compensation expense ([$80 x 90% x 4/4] [$19 + 19 + 16])
Paid-in capital stock options

19 - 16

19
19
19
19
16
16
18
18

EXPENSING STOCK OPTIONS

WHEN OPTIONS ARE EXERCISED
If half the options (five million shares) are exercised on July 11, 2014,
when the market price is $50 per share, the following journal entry is made:
July 11, 2014 ($ in millions)
Cash ($35 exercise price x 5 million shares)
175
Paid-in capital - stock options (1/2 account balance)
40
Common stock (5 million shares at $1 par per share)
Paid-in capital excess of par (to balance)

19 - 17

5
210

STOCK OPTIONS

Exercise 19-5
Exercise 19-6
Exercise 19-8

19 - 18

EXPENSING STOCK OPTIONS

WHEN VESTED OPTIONS EXPIRE WITHOUT BEING EXERCISED
If options that have vested expire without being exercised, the following
journal entry is made (assuming none of the options were exercised):
($ in millions)
Paid-in capital stock options (account balance)
80
Paid-in capital expiration of stock options

Exercise 19-7(#5)
BE 19-2 & 5

19 - 19

80

EXPENSING STOCK OPTIONS

PLANS WITH PERFORMANCE OR MARKET CONDITIONS
The way we account for such plans depends on whether the condition is
performance-based or market-based.
Performance Target Example:
An option may not be exercisable until a performance target is met.
The target could be:
-Divisional revenue,
-Earnings per share,
-Sales growth or
-ROA.
Market-related Targets:
-A specified stock price;
-A stock price change exceeding a particular index;

19 - 20

EXPENSING STOCK OPTIONS

Plans with Performance Conditions

If compensation from a stock option depends on meeting a performance target,

then whether we record compensation depends on whether or not we feel
its probable the target will be met.
If the initial expectation is that it is not probable that the target will be met,
we record no annual compensation expense.
2011:
NO ENTRY

2012:
NO ENTRY

If, after two years, the expectation is that it is probable that the target will be
met, we record the cumulative effect on compensation in 2013 earnings and
record compensation thereafter:
BE 19-6,
2013
Compensation expense ([$80 x ] - $0)
60
Paid-in capital stock options
60
BE 19-7,
2014
BE 19-8
Compensation expense ([$80 x 4/4] - $60)
20
Paid-in capital stock options
20
19 - 21

EXPENSING STOCK OPTIONS

Plans with Market Conditions
If the award contains a market condition (e.g., a stock
option with an exercisability requirement based on the
stock price reaching a specified level), then we
recognize compensation expense regardless of
when, if ever, the market condition is met.
Meaning, no special accounting is required!!
REASON:
The fair value estimate of the stock options based on
Option Pricing Models already incorporated market
conditions.

BE 19-9
19 - 22

Plans With Graded-Vesting

Rather than stock option plans vesting on a single date, more plans
awards specify that recipients gradually become eligible to exercise
their options rather than all at once. This is called graded vesting.
Accounting for compensation expense may be handled:

1
The company may estimate a
single fair value for each of the
options, even though they vest
over different time periods,
using a single weightedaverage expected life of the
options.

2
The company may use a slightly more
complex method because it usually results in
lower expense. In this approach, we view
each vesting group separately, as if it
were a separate award.
For example, a company may award
stock options that vest 25% in the first
year, 25% in second year, and 50% the
third years.
For accounting purposes we have three
separate awards.

19 - 23

Plans With Graded-Vesting

Illustration 19-3
(Page 1078)
Graded vesting

19 - 24

U.S. GAAP vs. IFRS

There are more similarities than differences in the treatment of stock
options. One major difference is the treatment of deferred tax assets
and when options have graded-vesting.

19 - 25

Account for each vesting

amount separately or account
for the entire award on the
straight-line basis over the
entire vesting period.

Straight-line choice is not

permitted. Companies not
required to recognize the award
that has vested by each reporting
date.

Employee Share Purchase Plans

Permit employees to buy shares directly from
their employer.
Usually the plan is considered compensatory,
and compensation expense is recorded.
Employees may buy 100 shares of no par stock
for $8.50 per share. The current market price is
$10.00. The $1.50 discount is recorded as
compensation expense:
Cash (100 $8.50)
Compensation expense (100 $1.50)
Common stock (100 $10.00)

Exercise 19-9
19 - 26

850
150
1,000
Market
Market value
value

Tax Implications
For tax purposes, plans can either qualify as an incentive stock
option plan (qualified) 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 non-qualified plan:
-the employee cant delay paying income tax, and
-the employer is permitted to deduct the difference between
the exercise price and the market price at the exercise date.
Example: Page 190: Additional Consideration: Tax Consequences.
19 - 27

U.S. GAAP vs. IFRS

There are more similarities than differences in the treatment of stock
options. One major difference is the treatment of deferred tax assets
and when options have graded-vesting.

19 - 28

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 deferred tax asset is not

created until the award is in
the money; that is it has intrinsic
value.

Home Work
Problem 19-1
Problem 19-2
Problem 19-3

19 - 29

Part B: Earnings Per Share

I. For analysts and the financial press, earnings per share is the most
frequently cited and reported measure of a companys performance.
A. EPS is reported in the income statement of all publicly
traded firms.
B. In general, EPS is simply earnings available to common
shareholders divided by the weighted average number of
common shares outstanding.

II. If a company has no potential common shares we consider

it to have a simple capital structure.
A. For a simple capital structure, a single presentation
of basic EPS is sufficient.
B. If there are no securities other than common stock and
the number of common shares remained unchanged, basic
EPS is simply net income divided by common shares.
19 - 30

EARNINGS AVAILABLE TO COMMON SHAREHOLDERS

Preferred dividends are subtracted from net income so that

earnings available to common shareholders is divided by
the weighted average number of common shares.
EXAMPLE:
Sovran Financial Corporation reported net income of $154
million in 2011 (tax rate 40%).
Its capital structure included:
Common stock
January 1
60 million common shares were outstanding
March 1
12 million new shares were sold
June 17
A 10% stock dividend was distributed
October 1
8 million shares were reacquired as treasury stock
Preferred stock, nonconvertible
January 1
5 million 8%, $10 par, shares outstanding

EARNINGS AVAILABLE TO COMMON SHAREHOLDERS

Basic EPS:
(amounts in millions, except per share amount)

net

preferred

income

dividends

$154
60(1.10)

$4 *

= $150 = $2
+ 12 (10/12)(1.10) 8 (3/12) = 75

Shares
new
at Jan. 1
shares
_____stock dividend_______
adjustment

treasury
shares

5,000,000 x $10 x 8% = $4

EXERCISE 19-14

Diluted Earnings Per Share

When a company has securities that could potentially
Dilute (i.e., reduce) earnings per share, it is classified as a
complex capital structure.
These potential common shares include stock options
And Convertible securities.
The company reports both basic and diluted earnings per
share.
For diluted EPS, the impact of each potentially dilutive
security is reflected by calculating earnings per share
as if the security already had been exercised or converted
into additional common shares.

19 - 33

Diluted Earnings Per Share

Potential
Potential Common
Common Shares:
Shares:
Stock
options, rights,
rights, and
and
Stock options,
warrants
warrants
Convertible
Convertible bonds
bonds and
and stock
stock
Contingent
stock
Contingent common
common stock
issues
issues
Contingently
issuable
shares

Complex Capital Structure

(dual EPS)

Stock
Options

Convertible
securities

Treasury
stock method

If-converted
method

Dilution/Antidilution Test

May Report Basic EPS and Diluted EPS

19 - 34

Options, Rights, and Warrants

The
The treasury
treasury stock
stock method
method
assumes
assumes that
that proceeds
proceeds
from
from the
the exercise
exercise of
of
options
options are
are used
used to
to
purchase
purchase treasury
treasury shares
shares..

At
average
market
This
method
usually
results
This method usually results
price

in
in aa net
net increase
increase in
in shares
shares
included
included in
in the
the
denominator
denominator of
of the
the
calculation
calculation of
of diluted
diluted
earnings
earnings per
per share.
share.
19 - 35

Proceeds

Used to

Purchase
treasury
shares

Options, Rights, and Warrants

1. Determine new shares from assumed exercise of stock options
Proceeds
Proceeds from
from assumed
assumed exercise
exercise
Average-of-period
Average-of-period market
market price
price of
of stock
stock
2. Compute shares purchased from the treasury.
3. Compute the incremental shares assumed outstanding:

New shares from assumed exercise

Less: Treasury shares assumed purchased
= Net increase in shares outstanding

(1)
(2)
(3)

Illustration 19-9 (Page 202): Stock Options

Exercise 19-15 & 19-16
19 - 36

Options, Rights, and Warrants

When
When the
the exercise
exercise price
price
exceeds
exceeds the
the market
market price
price,,
the
the securities
securities are
are antidilutive
antidilutive
and
and are
are excluded
excluded from
from the
the
calculation
calculation of
of diluted
diluted EPS.
EPS.

19 - 37

Convertible Securities
The if-converted method is used for
Convertible debt and equity
securities.
The method assumes conversion occurs
as of the beginning of the period or date
of issuance, if later.

19 - 38

Restricted Stock Awards

Restricted stock awards are quickly replacing
stock options as the share-based compensation
plan of choice. Like stock options, the treasury
stock method is used to calculate the number of
shares in the denominator of the EPS equation.
Unlike stock option, employees do not pay to
acquire their shares of stock.
No adjustment to the numerator
Denominator is increased using treasury method

19 - 39

Summary

19 - 40

Summary

19 - 41

Financial Statement Presentation

Report EPS data separately for:
1. Income from Continuing Operations
2. Separately Reported Items
a) Discontinued Operations
b) Extraordinary Items
3. Net Income

19 - 42

Appendix 19A Option-Pricing Theory

Intrinsic
Intrinsic value
value is
is the
the benefit
benefit the
the holder
holder of
of an
an
option
option would
would realize
realize by
by exercising
exercising the
the option
option
rather
rather than
than buying
buying the
the underlying
underlying stock
stock directly.
directly.
An
An option
option that
that permits
permits an
an employee
employee to
to buy
buy $25
$25
stock
stock for
for $10,
$10, has
has an
an intrinsic
intrinsic value
value of
of $15.
$15.
Options
Options have
have aa time
time
value
value because
because the
the
holder
holder of
of an
an option
option does
does
not
not have
have to
to pay
pay the
the
exercise
exercise price
price until
until the
the
option
option is
is exercised.
exercised.
19 - 43

Summary
The
The fair
fair value
value of
of an
an option
option is
is (a)
(a) its
its intrinsic
intrinsic value
value plus
plus (b)
(b)
its
its time
time value
value of
of money
money plus
plus (c)
(c) its
its volatility
volatility component.
component.

19 - 44

Appendix 19B - Stock Appreciation Rights

A. SARs enable an executive to benefit by the amount
that the market price of the companys stock rises,
but without having to buy shares.
B. The executive receives the share appreciation at
exercise that has occurred since the date of grant.
C. Share appreciation is the increase in the market
price over a pre-specified price (usually the market price
at the date of grant).

19 - 45

Appendix 19B - Stock Appreciation Rights

The SARs are considered to be equity if the
employer can elect to settle in shares of stock.
The amount of compensation is estimated at the
grant date as the fair value of the SARs.
Usually the same as the fair
value of a stock option with
similar terms.

This amount is expensed over the service period.

19 - 46

Stock Appreciation Rights

The SARs are considered to be a liability if the

employee can elect to receive cash upon settlement.

In that case, the amount of compensation (and
related liability) is estimated each period and
continuously adjusted to reflect changes in the fair
value of the SARs until the compensation is finally
paid.

The current expense (and adjustment to the liability)

is the fraction of the total compensation earned to
date by recipients of the SARs (based on the
elapsed percentage of the service period), reduced
by any amounts expensed in prior periods.

19 - 47

End of Chapter 19