Page 475 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 461

As for accounting treatment, the SAR is treated as if it were a stock option, with the fair
value determined at date of grant using an option pricing model and the expense accrued
over the vesting period. FAS 123R put SARs and stock options on an equal footing. Under
APB 25 nondiscounted stock options had no expense charge, and SARs were subject to
variable accounting trued up at time of exercise. Now both have a fair-value cost based on the
appreciation in stock price on date of grant.
Eligibility. The removal of the variable-accounting requirement under FAS 123R has
expanded the eligibility for SARs. Freestanding SARs settled in stock may be even
more advantageous than stock options because of less dilution for appreciation of less than
100 percent.
Frequency. The SAR is typically attached to the stock option at time of grant. If granted
later, the fair-value expense charge would be determined at date of grant. Typically this action
would be because of low stock-price appreciation and wanting to avoid the executive having
to put up the cash and experience the downside risk of a falling stock. But with cashless
exercises available, this later-date grant is avoided.
FASB Interpretation No. 31 requires that when stock or cash is available under payout,
it will be assumed to be stock unless there is a reasonable basis for assuming otherwise.
A resolution by the compensation committee to make SAR settlements in cash would
presumably meet this reasonable basis. If the executive had a choice, it would probably be
necessary to assume a stock settlement. However, if the executive decided to exercise
the stock option rather than take the SAR, the accruals established as a charge to earnings
logically would be eliminated since the SAR liability has been removed. The advantage of
paying the 16(b) executive (defined as an insider by the SEC) in cash rather than stock is
that the individual has no downside risk during the six-month period following exercise.
Also, a cash-settled SAR has the same net effect to the executive as a cashless stock option
exercise. The advantage to the company with the SAR is less dilution; the disadvantage is
variable accounting with exercised if it is assumed it will be settled in cash. FASB
Interpretation No. 128 later ruled that the determination is made each period based on
available facts.
Exercise Period. Probably the most common approach is to make the SAR exercisable at
the same time(s) as the underlying stock option.
Some plans put limitations on this tandem option-SAR arrangement by requiring that a
minimum percentage of the option must be exercised for the full stock—thereby putting a
portion of the executive’s potential growth at risk with this investment (exercise price). This
approach could be very unattractive to 16(b) executives due to financing problems.
Other plans allow recipients to exercise the SAR only within prescribed time periods
(i.e., windows) each year. Such periods may be limited, such as the 10 days following
quarterly earnings statements, and may apply to 16(b) executives and others, for stock as well
as cash settlements. It is not surprising that some companies have decided to handle the
exercise of the stock option in the same manner. All plans have to be carefully viewed in light
of Section 409A (“Deferred Compensation”) of the Internal Revenue Code.
In addition, companies need to decide whether or not to keep the SAR open after death
or other termination. If so, they may want to limit the number of shares (i.e., the spread)
available on date of termination (rather than allow continued recognition of market growth)
or value at time of exercise, whichever is less.