Page 424 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

410 The Complete Guide to Executive Compensation

Because of the lack of flexibility in being able to adjust the charge based on performance, open
valuation models (which will be described later) are probably preferable to closed models.
A performance condition plan is based on company internal financial performance. It
may be either solely in relation to a defined target (i.e. absolute performance) or relative to
the financial (not stock price) performance of selected companies (i.e. relative performance).
Values determined at time of grant may be adjusted based on outcome.
In accord with FIN 28, a stock option with an annual 25% installment vesting apparently
would have annual charges of 52.08%, 27.09%, 14.58%, and 6.25% of the fair value for the
four-year period not 25% a year.
If the charge to earnings and the actual tax deduction are different, an adjustment is made
to the Additional Paid in Capital (APIC) pool. However, if the tax deduction is less than the
charge to earnings, and the APIC pool is less than the adjustment, it becomes a current
charge to income tax expense. For example, for an option grant with a Black-Scholes value
of $9 per share that vests over three years (assuming no expected forfeitures), a grant size of
100,000 shares, and a strike price of $20 a share, $900,000 would be expensed over the three
year period. A tax deferred asset of $360,000 would be generated assuming a 40% effective
tax rate and the APIC pool would be increased by the $900,000 expense. If the options are
eventually exercised at $25 a share, the actual tax deduction would be $500,000 (i.e., $25–$20
times 100,000 shares) not $900,000. The tax benefit would $200,000 (i.e., 40% of $500,000).
Therefore, the adjustment to the APIC pool would be a reduction of $160,000 (i.e., $200,000
minus $360,000). If the APIC pool is less than $160,000, the difference would a a charge to
income tax expense.
For awards settled in cash or other assets, the fair value is determined at settlement date.
These are called liability awards, which have a variable accrual (market to market) until time
of settlement. The two types of awards are summarized in Table 8-2.

Type Settlement Determination Date Method

Equity Stock Grant date Fair value
Liability Cash Settlement date Actual value

Table 8-2. Types of awards under FAS 123R

The company has a choice as to the appropriate option pricing model to use. These
include closed-form models such as the Black-Scholes formula and open-form model such as
the binomial model with a lattice formula. The SEC indicated in 2005 (Staff Accounting
Bulletin No. 107) that different models may be used for different type awards. Decisions and
estimates will not be questioned if made in good faith.
The Black-Scholes model is the most widely used model for estimating the present value of
stock options granted by a company to its employees. In 1973, Fischer Black and Myron
Scholes developed the formula at the University of Chicago. It includes option price, price
of an underlying security, stock-price volatility, risk-free rate of return, dividend yield, and
expected term of the option grant. This is shown in Table 8-3. Designed to value shorter-
term, freely traded options, typically of about six months, one could argue that it may not be
appropriate for estimating the value of a 10-year option that is not freely traded or even
transferable. Since Myron Scholes and Robert Merton won a 1997 prize in academic science