Page 423 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 409

employee stock plans. Once adopted, the company was expected to continue to use the
method selected.
The Debate. No sooner had the standard been issued than many people argued that
expensing should be mandatory and not buried in a footnote. A number of reasons were
given, but the two most popular were as follows: (1) there should be an expense if companies
were allowed to have a tax deduction (triggered by ordinary income at time of exercising the
option), and (2) the stock option was really a call option given in exchange for future service
and was therefore compensation.
Another suggestion was that expense be recognized at the time the individual exercised
the stock option, accruing the expense over the period prior to that date. This would
definitely have the expense equal the tax deduction. However, as variable accounting it would
definitely be more expensive in a rising stock market than would grant-date fair value.
Some argued that the true annual cost of an equity plan is the accrued gain. This is a
combination of actual gains (exercised stock options plus vested stock awards) plus potential
gains in stock options (both vested and nonvested) plus nonvested stock awards less the
potential gains of those items at the beginning of the year. For example, if the executive
exercised stock options worth $3 million and became vested in $2 million of stock, the
realized gain was $5 million. If the potential gain in stock options and nonvested stock
was $10 million at the end of the year and $6 million at the beginning of the year,
the accrued gain for the year was $9 million [i.e., (10 6) 5]. It is hard to argue that
this is not a more appropriate measurement to use versus company performance than any
present-value estimate. If the previous year the executive’s accrued gain was $7 million, the
increase was 29 percent. This would be easy to compare with the increase in stock price for
the year.
Lined up on the other side were those who indicated there was no compensation expense
but rather a transfer of ownership through the issuance of shares (thereby diluting the value
of other shareholders). But the argument for mandatory expensing was given a boost when
the International Accounting Standards Board (IASB) required the expensing of stock
options in Europe.
The Decision. After considering a number of alternatives, FASB issued FAS 123R, “Share-
Based Payment.” It repealed APB 25 and replaced FAS 123 with a mandate that all employee
equity awards be expensed at fair value. “Fair value” is considered to be the price that would
be paid or received in exchange for an asset based on terms and conditions of the sale. This
replaced the intrinsic method of APB 25, which measured the difference between stock price at
time of grant and employee price.
The fair value is determined at grant date for awards settled in stock, and the fixed a
mount is accrued over the period of vesting. This would include full-value awards such as stock
awards of various types with their underlying value and appreciation awards such as stock
options and stock appreciation rights using an option pricing model. These are called equity
awards. The vesting (and exercisability) of equity awards is based on time, performance, and/or
stock prices. These three conditions will be reviewed for stock options, stock appreciation
rights, and stock awards later in the chapter.
FAS 123R defines equity awards as either market condition or performance condition plans.
A market condition plan measures company stock appreciation and/or the stock relative to
other selected companies. The grant value is not subject to adjustment based on performance
but apparently can be adjusted for participant terminations during the vesting period.