FAS 123(R) avoiding the unexpected. G. Edgar Adkins, Jr., CPA

FAS 123(R) avoiding the unexpected G. Edgar Adkins, Jr., CPA

FAS 123(R) avoiding the unexpected 2 Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (FAS 123(R)) has ushered in dramatic changes to the world of accounting for equity-based compensation. At 286 pages, FAS 123(R) is the lengthiest of all the Statements of Financial Accounting Standards. By now, most compensation professionals have become familiar with the basic tenets of the new standard, since FAS 123(R) is already in effect for most employers. 1 This article provides a brief overview of FAS 123(R), and then moves on to more advanced issues. Specifically, the article focuses on aspects of FAS 123(R) that can cause volatility or unexpected results. It is vitally important that compensation professionals broaden their understanding of FAS 123(R) in order to be aware of these potentially surprising results. FAS 123(R) highlights Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, (APB 25) was issued in October 1972. Employers were permitted to use APB 25 to measure compensation cost reported in their income statements until FAS 123(R) went into effect. APB 25 used the intrinsic value method to measure compensation cost associated with stock issued to employees. 2 Stock options were particularly popular under APB 25. The following formula was used to measure the intrinsic value of stock options: Fair market value of the stock on the date the option was granted Minus the exercise price of the option Equals the intrinsic value of the option Most employers issued options that had an exercise price equal to the fair market value of the stock on the option s grant date; thus, the intrinsic value was $0, and no compensation cost was recognized. Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, went into effect in 1995 and required employers to disclose the value of stock-based compensation, such as stock options, in the footnotes of their financial statements. Employers could also choose to 1 Large public employers must adopt FAS 123(R) in the first quarter of fiscal years beginning after June 15, 2005. Small public employers (generally, annual revenues or market capitalization greater than $25 million) must adopt in the first quarter of fiscal years beginning after Dec. 15, 2005. Privately held employers must adopt in the first fiscal year beginning after Dec. 15, 2005. 2 Accounting for Stock Issued to Employees, APB Opinion No. 25, 10 (Accounting Principles Bd. 1972).

FAS 123(R) avoiding the unexpected 3 record and report the value of stock options as compensation cost on their income statement, but few chose to do so. FAS 123(R) has ended this choice: employers are now required to record and report the value of stock options. FAS 123(R) sets forth the following basic requirements: The fair value of a share-based payment is measured at the date of grant. If the payment is a stock option, then the fair value is determined by using a stock option valuation model. 3 Fair value is recognized as compensation cost on the income statement over the vesting period. 4 Forfeitures are estimated in advance, and the compensation cost is adjusted accordingly. The compensation cost is not reversed for options that vest, but are never exercised (e.g., underwater options). Beyond the basics: unexpected results under FAS 123(R) As noted above, there are certain aspects of FAS 123(R) that can cause volatility in an employer s income, or can produce other types of unexpected results. The remainder of this article focuses on the following specific issues that can lead to unexpected results: Liability awards Income tax accounting Performance conditions Market conditions Modifications Compensation cost for retirement-eligible individuals Compensation cost for graded vesting of awards Liability awards Most employers will want to avoid liability award treatment under FAS 123(R). To illustrate why, suppose someone offers to give you $1 million. Would you prefer to have the $1 million treated as a liability or equity? Liability treatment means you have to pay the money back. Equity treatment means you get to keep the money, free and clear. Obviously, equity treatment is a better choice. The impact of equity versus liability treatment on your balance sheet is shown in Illustration 1. Illustration 1 Liability vs equity treatment on the balance sheet Liability treatment Equity treatment Liability $1,000,000 Liability $0 Equity $0 Equity $1,000,000 Total $1,000,000 Total $1,000,000 Employers are presented with the same choice between equity and liability awards with respect to the design of share-based payments, and many will choose to design their plans as equity arrangements. Generally, a liability award is settled in cash, while an equity award is settled in the employer s stock. Typically, a stock option is settled in stock; that is, upon exercise of the option, the employee receives stock. Thus, the option is an equity award. In 3 Option valuation models include the Black-Scholes model, as well as lattice models. A discussion of these models is beyond the scope of this article. 4 In some cases, the fair value is capitalized rather than recognized as an expense on the income statement, e.g., when the share-based payment is made in connection with an employee s services to construct fixed assets.

FAS 123(R) avoiding the unexpected 4 contrast, a stock appreciation right ( SAR ) might be designed to be settled in cash; that is, the employee is paid cash for the appreciation in the value of the stock. Thus, the SAR is a liability award. The delineation between liability and equity awards is considerably more complex than the foregoing explanation. The degree of complexity could cause enough confusion that an employer could inadvertently design a plan in a manner that causes it to be treated as a liability award. Table 1 Liability award example Background facts: - 1,000 cash-settled SARs (a liability award) - Vesting period: 4 years - Expiration: 6 years from date of grant Fair values at the end of each year: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 $10 7 12 15 11 12 In addition to the unfavorable balance sheet treatment described above for a liability award, liability awards have an unfavorable impact on an employer s income statement. When an award is a liability award, its fair value must be re-measured each reporting period. 5,6 The compensation cost and corresponding liability for the award are adjusted for every period that the award is outstanding, based on the newly-measured fair value. In contrast, the fair value of an equity award is measured only on the grant date; it is not re-measured each reporting period. If an employer classifies an award as equity when it should have been treated as a liability (or vice versa), then the employer will have an erroneous balance sheet and income statement for each and every period in which the award is outstanding. Table 1 provides the background facts for an example that will illustrate the impact of a liability award on the income statement. Table 2 shows the calculation of the compensation cost that is recognized on the income statement for Years 1 6. TABLE 2 Liability award example Annual compensation cost Year Compensation cost calculation Compensation cost amount Year 1 $1,000 x 10 x.25 $2,500 Year 2 ($1,000 x 7 x 0.5) - $2,500 1,000 Year 3 ($1,000 x 12 x 0.75) - $3,500 5,500 Year 4 ($1,000 x 15) - $9,000 6,000 Year 5 ($1,000 x 11) - $15,000 (4,000) Year 6 ($1,000 x 12) - $11,000 1,000 The calculation for Year 1 is relatively easy. There are 1,000 SARs with a fair value of $10 each. Thus, the total fair value is $10,000. Since the options vest over a four-year period, one-quarter of the total fair value will be recognized as compensation cost in Year 1. Thus, the compensation cost for Year 1 is $2,500 ($10,000 x ¼). At the end of Year 2, the fair value is re-measured, and it has dropped from $10 to $7. Thus, the total fair value is now $7, 000 rather than $10,000. Given the four-year vesting period, one-half of the total fair value should be recognized as compensation cost by the end of Year 2. This amount is $3,500 ($7,000 of total compensation cost times one-half). Of this amount, $2,500 of compensation cost has already been recognized in Year 1. Thus, the additional amount of compensation cost to recognize in Year 2 is $1,000 ($3,500 2,500). This same procedure continues in subsequent years. Even though the 5 Share-Based Payment, Statement of Fin. Accounting Standards No. 123 (revised 2004), 36 (Fin. Accounting Standards Bd. 2004) [hereinafter FAS 123(R)]. 6 A nonpublic entity may choose between measuring its liability awards at fair value or intrinsic value. Id. at 38.

FAS 123(R) avoiding the unexpected 5 award is fully vested as of the end of Year 4, the re-measurement of fair value must continue for each year beyond Year 4 that the SARs remain outstanding. As the table shows, there is a negative compensation cost in Year 5, because the fair value drops from $15 per SAR to $11 per SAR. This entire decrease is reflected in Year 5, because the SARs are already fully vested, and there is no further vesting period over which to spread the decrease. As Table 2 shows, these SARs create considerable volatility in the income statement, ranging from compensation cost of $6,000 in Year 4 to a negative $4,000 in Year 5. This is a $10,000 swing in compensation cost between years for SARs whose ultimate total compensation cost is only $12,000. Illustration 2 depicts the volatility in compensation cost that results from this cash-settled SAR. Illustration 2 Liability award example Annual compensation cost volatility 8,000 6,000 4,000 2,000 0 (2,000) (4,000) (6,000) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Series1 Suppose the SARs above were designed to be settled in stock rather than in cash. The SARs would then be classified as an equity award, and their impact on the income statement would be considerably different from that described above. The fair value would be Table 3 Equity award example Annual compensation cost Year Compensation cost Year 1 $2,500 Year 2 2,500 Year 3 2,500 Year 4 2,500 Year 5 0 Year 6 0 measured only once, at the grant date. This fixed amount of fair value would be the total compensation cost, and would be recognized in the income statement over the four-year vesting period. After Year 4, no further compensation cost would be recognized, regardless of how long the SARs remain outstanding. The total compensation cost would simply be the $10 grant-date fair value, multiplied by the number of SARs issued. Thus, the total compensation cost is $10,000 ($10 x 1,000). The annual compensation cost for each year in the four-year vesting period is $2,500 ($10,000 x ¼). Table 3 shows the compensation cost for each year for SARs that are treated as an equity award.

FAS 123(R) avoiding the unexpected 6 Illustration 3 is helpful in comparing the income statement impact of liability versus equity awards, using the numbers from the preceding examples. Illustration 3 Liability vs equity awards Annual compensation cost comparison 8,000 6,000 4,000 2,000 0 (2,000) (4,000) (6,000) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Liability Equity To summarize, liability awards are less favorable on the balance sheet than equity awards, and liability awards may cause volatility in the income statement. Therefore, it is important to understand what causes liability classification, especially if the employer desires to avoid liability classification. Gaining a thorough understanding of this issue is no small feat; the rules regarding the determination of liability classification under FAS 123(R) represent one of the most complex issues surrounding the accounting for share-based payments. The general rule under FAS 123(R) is that liability classification is required if an entity can be required under any circumstances to settle an option or other shared-based payment by transferring cash or other assets. Examples of liability awards include stock options and stock appreciation rights ( SARs ) that are settled in cash. There are several share-based payment provisions that can cause a shared-based payment to be classified as a liability. These provisions include: Substantive terms of the award Tax withholding Embedded puts and calls Mandatorily redeemable shares Indexing to factors other than performance or market conditions We will examine each of these situations below.

FAS 123(R) avoiding the unexpected 7 Substantive terms of the award It is important to always examine the substantive terms of the award in order to determine whether the award is a liability. The classification of equity versus liability treatment is generally based on the plan s written terms. However, an employer s past practices may indicate that the award s substantive terms differ from its written terms; in this situation, the plan s substantive terms will be used to determine whether the award is a liability. 7 On the other hand, if the employee has the choice of settling an award in shares or cash, then the award is a liability award. If the employer has the choice of settling an award in shares or cash, the substantive terms of the award must be examined further to determine whether it is a liability award. The award is a liability award if the employer predominately settles awards in cash. In addition, the award is a liability award if the employer settles awards in cash when requested to do so by employees. 8 Embedded puts and calls FAS 123(R) takes the position that if an employee does not truly take on the risks and benefits of share ownership, then the award is a liability rather than an equity award. Puts and calls are one aspect of a share-based payment that may safeguard an employee from taking on these risks. Thus, puts and calls may cause the payment to be treated as a liability. Share-based payments are sometimes issued with a put and/or a call as part of the terms. A put is a right on the part of the employee to sell the stock to the employer. A call is a right on the part of the employer to buy the stock from the employee. Any of the following provisions related to a put or call will result in liability classification: 9 The employee can exercise the put before the share has been vested for six months. It is probable that the employer would permit the employee to exercise the put before the share has been vested for six months. It is probable that the employer would exercise its call right before the share has been vested for six months. A put or call that cannot be exercised until six months after the share becomes vested will not result in liability treatment. Another aspect of a put that causes liability treatment is a fixed repurchase price. When there is a fixed repurchase price, the employee does not truly bear the risk of ownership. The following examples illustrate the rules for determining whether puts and calls will cause liability classification: Example 1: Immediately upon vesting, the employee can sell the shares back to the employer at fair market value. This award is treated as a liability, because the employee is not at risk for at least six months after vesting. 7 Id. at 34. 8 Id. 9 Id. at 31.

FAS 123(R) avoiding the unexpected 8 Example 2: The employee has no written put right, but the employer routinely repurchases vested shares from employees whenever they request it. This award is treated as a liability, because the employer is willing to repurchase the shares earlier than six months after the vesting date. Example 3: The employee cannot sell the shares to the employer until at least six months after vesting. However, the sale price is fixed at $50 per share. This award is treated as a liability, because the employee is protected from declines in the stock price below $50. Mandatorily redeemable shares Liability classification is required when there are mandatorily redeemable shares. 10 Mandatorily redeemable shares refers to a situation where both the employer and the employee are unconditionally obligated to redeem shares for cash at a specified or determinable date, or upon an event that is certain to occur (such as upon the employee s death). However, some mandatorily redeemable instruments are not subject to liability classification. 11 The rules are different for entities that file with the Securities and Exchange Commission (SEC) and non-sec filers. The rules are complex, and a further discussion of the rules is beyond the scope of this article. Indexing to factors other than performance or market conditions A share-based payment is treated as a liability when the exercise price is tied to factors other than performance conditions or market conditions. 12 Performance conditions refer to factors that relate to the employer s own operations, while market conditions relate to the employer s share price. Examples of factors used to determine the exercise price that will cause the option to be treated as a liability include the following: Commodity prices Consumer price index Foreign exchange rates There are some exceptions to the foreign exchange rate example above. An option with an exercise price that is denominated in foreign currency is not required to be classified as a liability if both of the following conditions are met: 13 The award otherwise qualifies for equity classification The foreign currency is either the functional currency of the employer s foreign operation, or the currency in which the employee s pay is denominated For example, suppose an option has a fixed exercise price that is denominated in euros. The options are issued to employees of a foreign subsidiary whose functional currency is the euro. These options will be treated as equity awards (assuming they otherwise qualify for equity classification). Suppose that in the 10 Id. at 32. 11 Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150,Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, FASB Staff Position No. FAS 150-3 (Fin. Accounting Standards Bd. 2003). 12 FAS 123R), supra note 7, at 33. 13 Id.

FAS 123(R) avoiding the unexpected 9 example above, the facts are changed so that the subsidiary s functional currency is U.S. dollars. The options can still be treated as equity awards, as long as the employee s pay is denominated in euros. There are other practices which have some characteristics of a liability award, but generally will not trigger liability accounting under FAS 123(R). These practices include tax withholding, cashless exercises and cash settlements upon the occurrence of a contingent event. Each of these practices is discussed below. Tax withholding If an employer withholds required taxes from a stock option exercise or other shared-based payment and transfers the net amount (after taxes) to the employee, the withholding has the effect of settling a part of the award in cash. This is the case because the employer remits the withheld taxes to the appropriate governmental agency in cash. Thus, under the general rules, the award would be treated as a liability. However, the withholding will not cause liability treatment as long as the withholding is limited to the minimum statutory withholding rate. 14 If an amount greater than the minimum rate is withheld, the award is treated as a liability. Also, if the employee has the discretion to request that taxes be withheld at a rate greater than the required minimum rate, then the award will be treated as a liability. 15 Cashless exercises Many employers allow options to be exercised by employees on a cashless basis. Using this approach, the employee receives an amount of shares that is net of the exercise price. For example, the employee exercises options to receive stock with a value of $10,000. The exercise price is $3,000. The employee receives shares worth $7,000, rather than paying $3,000 in cash and receiving $10,000 in shares. Cashless exercises do not result in liability treatment, assuming that the option otherwise qualifies as an equity award. Unlike prior accounting rules, it is no longer necessary for the cashless exercise to be carried out by a broker. In other words, the option will still be treated as an equity award, even when the employer itself carries out the cashless exercise. Cash settlements upon the occurrence of a contingent event The general rule under FAS 123(R) is that an award that can be settled in cash upon the election of the employee must be classified as a liability. However, the Financial Accounting Standards Board (FASB) has taken the position that a cash settlement feature that can be exercised only upon the occurrence of a contingent event that is outside the employee s control is not treated as a liability until it becomes probable that the event will occur. 16 For this purpose, the term probable means likely to occur. 17 For example, suppose a stock option can be settled only in stock, with one exception. The exception is that upon a change in control, the employee may exercise the option and receive cash rather than stock. This provision will not cause the option to be treated as a liability award until it becomes probable that a change in control will occur. 14 Id. at 35. 15 Id. 16 Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event, FASB Staff Position No. FAS 123(R)-4, (Fin. Accounting Standards Bd. 2006). 17 Accounting for Contingencies, Statement of Fin. Accounting Standards No. 5, 3 (Fin. Accounting Standards Bd. 1975).

FAS 123(R) avoiding the unexpected 10 Income tax accounting Another area of FAS 123(R) that can produce surprising results relates to the accounting for income taxes for share-based payments. The accounting for income taxes can cause volatility in the income statement when there is a so-called tax shortfall. In order to understand how tax shortfalls arise, it is important to first understand the basic income tax accounting rules. For purposes of this discussion, we will assume that an employer grants nonqualified stock options to an employee. The employer does not receive an income tax deduction until the employee exercises the options. 18 The amount of the deduction will be the fair market value of the stock on the exercise date, less the exercise price paid by the employee. However, for purposes of recognizing the income tax deduction on the income statement, the income tax benefit that results from the income tax deduction is estimated in advance, and is recorded for the income statement at the same time that the compensation cost related to the options is being recognized. Table 4 summarizes the differences in both the timing and amount of the income tax benefit on the income statement versus the actual deduction on the income tax return. Table 4 Nonqualified stock options Differences in income statement and income tax return treatment Attributes Income statement Income tax return Timing Amount Compensation cost is recognized over the vesting period. Total compensation cost is equal to the fair value. Income tax deduction is taken upon exercise of the option. The amount of income tax deduction is the intrinsic value on the exercise date (i.e., fair market value minus the exercise price). Each time an option is exercised, the employer must compare the amount of the income tax deduction to the amount of compensation cost that was recognized on the income statement for those options. If the tax deduction amount is greater than the book compensation cost, the employer has an excess tax benefit. On the other hand, if the tax deduction amount is less than the book compensation cost, then the employer has a tax shortfall. The accounting is somewhat different for excess tax benefits and tax shortfalls, and it is tax shortfalls that can produce unexpected results on the income statement. Table 5 Excess tax benefit example Income tax benefit on tax return when option is exercised Income tax benefit recorded on books at the same time compensation cost is recognized $4,800 4,000 Excess tax benefit $800 Table 5 shows a situation resulting in an excess tax benefit. Upon the exercise of the option, the employer recognizes the $800 excess tax benefit by increasing an account called Additional Paid-in Capital (APIC). 19 APIC is an equity account on the balance sheet. Thus, excess tax benefits are not reflected on the income statement, and cannot produce any volatility in the employer s income. 18 Treas. Reg. 1.83-6(a)(1). 19 FAS 123(R), supra note 7, at 62.

FAS 123(R) avoiding the unexpected 11 Table 6 Tax shortfall example Income tax benefit on tax return when option is exercised Income tax benefit recorded on books at the same time compensation cost is recognized $2,800 4,000 Tax shortfall $1,200 Table 6 illustrates a situation where there is a tax shortfall. When an employer experiences a tax shortfall, the general rule is that the tax shortfall is charged to income tax expense. 20 Since income tax expense is shown on the income statement, a tax shortfall causes a detrimental, unexpected impact on net income. Fortunately, an employer is not required to charge a tax shortfall to income tax expense on the income statement if it has prior excess tax benefits. An employer goes through the following steps to determine where to record tax shortfalls: 1 Examine accounting records to determine if there have been prior excess tax benefits. 2 If there have been excess tax benefits in the past, then charge the tax shortfall to the APIC account, up to the amount of prior excess tax benefits. 3 After that, the tax shortfall must be charged in income tax expense. FAS 123(R) refers to the cumulative amount of prior excess tax benefits as the APIC pool. Upon the adoption of FAS 123(R), an employer must go through a complex and data-intensive process to determine its beginning APIC pool that is, the pool of excess tax benefits that exists upon the first day it adopts FAS 123(R). An alternative method of calculating the beginning APIC pool is available for any employer, including those that do not have prior data available, or for employers who do not wish to devote the time and resources that are needed to calculate the beginning APIC pool. 21 The larger an employer s APIC pool the better, since the tax shortfalls do not increase income tax expense as long as the employer still has an APIC pool. Performance conditions Another aspect of share-based payments that can cause surprises in the income statement relates to vesting that is conditioned on the achievement of certain performance goals. These performance conditions relate to the employer s own operations or activities. 22 Examples of performance conditions include the following: Achievement of specified earnings or revenue growth of the employer or a division of the employer An EBITDA target (earnings before income taxes, depreciation and amortization) FDA approval of a product An initial public offering When an employer grants performance-vested awards, it must estimate the fair value of the payments, as well as the service period over which the awards will vest. The fair value is recognized as compensation cost over the service period, but only if the required performance conditions are probable of achievement. 23 As noted earlier, the term probable means likely to occur. The 20 Id. at 63. 21 Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, FASB Staff Position No. FAS 123(R)-3 (Fin. Accounting Standards Bd. 2005). 22 FAS 123(R), supra note 7, at Appendix E, p. 275. 23 Id. at 44.

FAS 123(R) avoiding the unexpected 12 employer is required to periodically reassess vesting and achievement expectations and revise the compensation cost as necessary. This reassessment process may result in earnings volatility. TABLE 7 Performance conditions example Background facts 1,000,000 options granted to employees Fair value of each option on grant date: $13 Vesting: Options vest if EBITDA increases an average of 6 percent over a 3-year period Forfeitures: It is estimated that employee turnover will result in the forfeiture of 10 percent of the options. Employer s estimate of the achievement of the performance condition as of the end of each year: Year 1 not probable Year 2 probable Year 3 achieved Table 7 provides the background facts for an example that will illustrate the impact of performance conditions on the income statement. The cost recognized in Year 1 is $0, because the employer has determined as of the end of Year 1 that it is not probable that the vesting conditions will be met. However, at the end of Year 2, the employer s financial outlook has improved, and the employer believes that it is now probable that the vesting conditions will be achieved. As a result, the employer must recognize compensation cost for Year 2. To determine the amount of compensation cost, the employer takes the following steps: 1. Determine the total number of options that will vest if the performance conditions are met: 1,000,000 options less 100,000 forfeited options (due to 10 percent turnover) = 900,000 vested options. 2. Determine the total compensation cost related to the options: 900,000 vested options x $13 fair value = $11,700,000. 3. Determine the cumulative compensation cost that should be recognized as of the end of Year 2: $11,700,000 x 2/3 (since two years of the total three-vesting period has been completed) = $7,800,000. 4. Determine the compensation cost to be recognized in Year 2: $7,800,000 cumulative compensation cost as of the end of Year 2 less $0 (amount of compensation cost recognized in Year 1) = $7,800,000. As of the end of Year 3, the performance condition has been achieved, and the options are fully vested. The employer will use a procedure similar to that of Year 2 to determine the compensation cost for Year 3, as follows: 1. Determine the cumulative compensation cost that should be recognized as of the end of Year 3: $11,700,000 x 3/3 (since all three years of the total three-vesting period have been completed) = $11,700,000. 2. Determine the compensation cost to be recognized in Year 3: $11,700,000 cumulative compensation cost as of the end of Year 3 less $7,800,000 (amount of compensation cost recognized in Years 1 and 2) = $3,900,000.

FAS 123(R) avoiding the unexpected 13 Illustration 4 depicts the volatility in compensation cost associated with the performance vesting. Illustration 4 Performance vesting example Annual compensation cost volatility 9,000,000 8,000,000 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 Year 1 Year 2 Year 3 Series1 If the employer had believed as of the end of each year that the performance achievement was probable, then the compensation cost recognized each year would have been $3,900,000. Thus, it is changes in the determination of whether the performance condition is probable that causes volatility on the income statement. Market conditions Some employers may choose to provide that share-based payments will vest upon the achievement of specified market conditions, e.g., an option that vests upon the achievement of a specified price of the employer s shares is a market condition option. Other market conditions include the achievement of a specified price of the employer s shares relative to a similar equity security or an index of similar equity securities. A market condition also includes the achievement of a specified amount of intrinsic value indexed to the employer s shares. Market conditions are taken into account in measuring the fair value of the award; the probability of achieving the market condition affects the fair value of the award. The fair value must then be recognized as compensation cost, regardless of whether the market condition is ever achieved. 24 Thus, compensation cost will be recognized for a market condition award, even if the award does not vest, e.g., assume that an option becomes exercisable only if the employer s share price increases at least as much as a competitor s share price (on a percentage basis) within the next two years. In this situation, the employer is required to recognize the compensation cost if the employee provides 24 Id. at 48.

FAS 123(R) avoiding the unexpected 14 services for two years, even if the option is never exercisable (because the share price did not increase as much as its competitor s share price during that period). 25 Modifications The accounting for modifications to awards is another important part of FAS 123(R). It is important for the compensation professional to fully understand the accounting impact of a modification. Common types of modifications include re-pricing, extending the term (i.e., providing the employee additional time to exercise), reducing the term, and increasing the number of awards or shares. The basic theory of accounting is that a modification is the exchange of an old grant for a new grant. In other words, the pre-modification grant is exchanged for the modified grant. The fair value of the award is measured immediately prior to the modification, as well as immediately after the modification. The increase in the fair value is recognized as additional compensation cost. 26 For example, assume that on Jan. 1, 2006, an employer issued 10,000 options to employees, each with an exercise price of $30 and a grant-date fair value of $8. As of Jan. 1, 2008, the share price had fallen to $20, so the employer lowers the exercise price of the options to $20. Table 8 lists the calculations that the employer would perform. Table 8 Modification example Fair value of re-priced option on Jan. 1, 2008 $5 Fair value of original option on Jan. 1, 2008-2 Incremental cost to be recognized $3 Total cost to recognize: Original fair value ($8 x 10,000) $80,000 Incremental cost 30,000 Total $110,000 The incremental cost of $30,000 must be recognized over the remaining service period (i.e., the vesting period). The compensation professional should be aware that if there is no remaining service period (i.e., the options are already fully vested), then the entire $30,000 incremental cost will need to be recognized immediately in the income statement. Compensation cost for retirement-eligible individuals Another area of FAS 123(R) that can lead to surprises relates to retirement-eligible individuals. To illustrate, suppose options are granted with a four-year vesting schedule. Suppose further that the options awarded to employees who are currently eligible for retirement continue to vest after termination; that is, if the employee retires, the options will continue to vest solely based on the passage of time. The following three situations illustrate the accounting treatment for these options: 25 It should be noted that if, in addition to failing to achieve the market condition, an employee fails to meet the award s requisite service period, the compensation cost is not recognized. The requisite service period for a market condition award may be implicit or derived, depending on the award s terms, e.g., suppose an award will become exercisable if the stock price increases by 50 percent at any time during a three-year period and suppose further that the lattice option valuation model that is used to calculate the award s fair value provides an estimate that the market condition will be met in two years. In this case, the requisite service period is two years. 26 Id. at 51.

FAS 123(R) avoiding the unexpected 15 Employee A is retirement eligible on the grant date. Thus, no service is required to earn the award (since vesting will continue to accrue even if the employee retires). As a result, the entire fair value of the options granted to Employee A must be recognized as compensation cost immediately upon grant. Employee B will become eligible for retirement at the end of Year 1. Thus, Employee B s requisite service period is one year. As a result, the fair value of the options granted to Employee B must be recognized as compensation cost over a one-year period. Employee C will become eligible for retirement at the end of Year 4. Thus, Employee C s requisite service period is four years, and the fair value of the options granted to Employee C will be recognized as compensation cost over a four-year period. Compensation cost for graded vesting of awards When an employer issues shared-based payments that vest based on a service condition, and the vesting is on a graded basis, the employer needs to make an accounting policy decision regarding the timing for recognizing the compensation cost associated with the payments. 27 The accounting policy decision applies to future awards. Thus, a compensation planner needs to be aware of the employer s accounting policy. Otherwise, the planner may be surprised by the actual impact of the award on the employer s income statement. Assume that an employer awards 1,000 options to an employee on Jan. 1, 2006. The fair value of the options on the grant date is $48,000. The options vest at the rate of 25 percent per year over a four-year period. The employer can choose between two methods to recognize the compensation cost associated with these options. The first method is the straight-line method. Under this method, the employer would simply recognize 25 percent of the total fair value each year for four years. Thus, the annual compensation cost is $12,000 ($48,000 x ¼). The second method is the graded-vesting attribution method. This method treats the grant as multiple awards (sometimes referred to as tranches ) and recognizes the cost on a straight-line basis separately for each award. This method accelerates the recognition of compensation cost. Table 9 Graded vesting attribution method Compensation cost 2006 2007 2008 2009 Total 1 st tranche 12,000 12,000 2 d tranche 6,000 6,000 12,000 3 rd tranche 4,000 4,000 4,000 12,000 4 th tranche 3,000 3,000 3,000 3,000 12,000 25,000 13,000 7,000 3,000 48,000 Table 9 shows the compensation cost for each year, using this accelerated method. The compensation planner who anticipated a cost of $12,000 for 2006 under the straight-line method would be very surprised to find that the cost is $25,000, which would be the case if the employer had previously made an accounting policy decision to use the accelerated method. 27 Id. at 42.

FAS 123(R) avoiding the unexpected 16 Illustration 5 depicts the differences between the straight-line and accelerated methods. Illustration 5 Comparison of straight-line and accelerated compensation cost recognition methods Annual compensation costs 30,000 25,000 20,000 15,000 10,000 Series1 Series2 5,000 0 1 2 3 4 To further depict the difference between these two cost recognition methods, Illustration 6 shows the percentage of total cost that has been recognized as of the end of each year. Illustration 6 Comparison of straight-line and accelerated compensation cost recognition methods Cumulative compensation costs Percentage of Cumulative Cost at Year-End 4 100% 100% Year 3 2 50% 75% 79% 94% 1 25% 52% 0% 20% 40% 60% 80% 100% 120% Percentage

FAS 123(R) avoiding the unexpected 17 Conclusion This article has illustrated that FAS 123(R) can indeed bring about surprising and volatile results on an employer s income statement. For example, an award that is treated as a liability continues to have an impact on the income statement, even after the award has become fully vested. The variation in the compensation cost of a liability award from one year to the next can be as great as the total ultimate compensation cost associated with the award. The accounting for income taxes can result in an additional income tax expense on the income statement when the tax deduction amount is less than the compensation cost that has been recognized on the income statement. Awards that vest based on the satisfaction of performance conditions can produce widely varying compensation costs from one year to the next if it is probable that the performance condition will be met one year, but it is determined that it is not probable that the condition will be met in the following year (or vice versa). Awards that vest based on market conditions may result in the recognition of compensation cost, regardless of whether the awards actually do vest. Modifications to awards may result in additional compensation cost; if the awards are already fully vested, then the entire additional cost must be recognized immediately when the modification is made. Awards granted to retirementeligible individuals may result in full and immediate recognition of compensation cost in certain circumstances. Finally, an employer that has made an accounting policy decision to use the graded-vested attribution method will find that the recognition of compensation cost will be heavily weighted towards the earlier years of the vesting period. It is important that compensation professionals be aware of these aspects of FAS 123(R) in order to either avoid the unexpected results, or at least be aware of the potential results.

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