Page 422 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

408 The Complete Guide to Executive Compensation

66,666 shares). This is not greater than the option on company B stock, which is $4 million
(i.e., $100 $60 times 100,000 shares) and therefore meets the first EITF 90-9 test. The
ratio of exercise price to market price for company B stock and company A stock is each 60
percent. Therefore, the ratio of exercise price to market price has not been reduced, and the
second EITF 90-9 test has been met. Since the option and vesting terms remain the same, the
third EITF 90-9 test has been met.
Alternatively, a part of the business could be spun off to shareholders. Spin-offs were
covered in Chapter 1. Options could exist for both the former company and the spin-off.
These are called split type options as the executive has a stock option in both companies. They
are also called stapled options. For example, if the company stock were considered to be worth
$100 a share before the spinoff and $80 afterward (with the spin-off worth $20 a share), exist-
ing parent company options would be repriced at 80 percent of value for 80 percent of the
number of shares, with the unused 20 percent creating new subsidiary options, assuming a
three-to-one stock exchange. If not, the previously described three-part test of EITF 90-9
would have to be met. They may operate independent of each other or be part of a single
option or stapled option. Both stapled and independent stock option grants are subject to
EITF 90-9. Alternatively, the spin-off executives might receive a concentrated stock option,
namely, all the options would be on the spin-off stock consistent with EITF 90-9.
Dividends are payable only on shares of issued stock. Therefore, shares under option do
not receive dividends (of course, they could receive dividend equivalents). The receipt of a
stock option grant is not a taxable event (at least in the United States); however, the exercise
or purchase of stock under an option does have tax consequences (as will be discussed later).
However, as of 1991, the grant date (not the exercise or purchase date) is considered a
purchase under Rule 16(b) for purposes of the six-month test on “insiders.” An insider is
defined by the Securities and Exchange Act as any person who owns 10 percent or more of
any class of stock in a publicly held company or is an officer or director of the company.
In 1996, the SEC went one step further and eliminated the requirement that either the
option or its shares had to be held for at least six months if a qualified transaction, thereby
significantly broadening their 1991 ruling.
The long-standing APB 25, issued by the Accounting Principles Board (APB) in 1972,
established the measurement date principle. It stated that expense should be determined for
stock-based plans on the first date the number of shares and the price paid by the recipient was
known. Stock option plans that stated at time of grant the number of shares and a price equal
to the fair market value (FMV) on that date incurred no charge to earnings since the “bargain”
was zero. However, when the number of shares or the price per share was not known at date
of grant, there was a charge when both were known. For example, if the period under which
options granted become exercisable was tied to some financial measurement (such as stock
price or earnings per share), the company would have to take a charge to earnings for the
difference between fair market value and option price when exercisable.
The FASB issued Financial Accounting Standard FAS 123 in 1995, permitting compa-
nies to make a choice between APB 25 or a present-value pricing model such as Black-
Scholes to measure the compensation expense for stock plans. If APB 25 were used, the FAS
123 calculations would have to be reported in a footnote. Studies have reported that if the
cost of stock options were charged to the earning statements rather than simply reported as
a footnote, earnings would be significantly reduced for those with high use of stock options.
In addition, a significant portion of cash would be used (negative cash flow) if some form of
cash payment replaced the options. Whatever approach was adopted had to be used for all