Accounting for Share-based Compensation Awards

Accounting for Share-based Compensation Awards Survey of Relevant Accounting Guidance San Francisco NASPP Chapter Meeting February 11, 2009 Takis Makridis Director, Professional Services

Agenda I. Various Forms of Share-Based Compensation. I. Compensation Expense II. Diluted Earnings per Share III. Deferred Taxes IV. Modification Accounting 2 2008 Equity Methods - Proprietary & Confidential

Forms of Share-Based Payment Compensation 3 2008 Equity Methods - Proprietary & Confidential

Share-Based Compensation Vehicles Companies generally issue: Stock options (incentive or non-qualified) Stock appreciation rights (SARs) Restricted stock (awards or units) Employee stock purchase plan shares (compensatory or non-compensatory) These awards are classified on the balance sheet as: Equity Liabilities generally if payout is in the form of cash Strings are inserted in an award to control (via performance or market conditions): Timing of vesting Quantity of shares earned Awards can be modified to change: Vesting (probable to improbable; improbable to probable) Other key terms such as the quantity of awards, option strike price, post-termination exercise window, etc. Balance sheet classification 4 2008 Equity Methods - Proprietary & Confidential

Key FAS 123R Terms The features to an award will interact with key terms in FAS 123R: Grant Date Measurement Date Service Inception Date Tranche Key terms and conditions are established. Employee begins to benefit from, or be adversely affected by, subsequent changes in the firm s share price. Shareholder approval is obtained (unless approval is a mere formality). Recipient meets the common law definition of employee. Date in which fair value is solidified. If equity award, equal to the grant date. If liability award, equal to the settlement date. Date in which the requisite service period begins. Be careful cases in which this date precedes the grant date are rare. (See Paragraph A79 of FAS 123R). Lowest common denominator of an award used to separate a grant into the components in which shares/units are actually earned. Never actually defined in FAS 123R! 5 2008 Equity Methods - Proprietary & Confidential

Amortization Methods Two techniques are generally permitted in FAS 123R: FIN 28 / Graded: grant is broken into its requisite tranches such that each tranche is viewed as a standalone grant, the cost of which is straight-lined: Straight-line: cost is attributed evenly across a grant based on the total vesting period and total number of shares expected to vest: Application to IFRS. 6 2008 Equity Methods - Proprietary & Confidential

Case 1 Performance-Based RSU Award Terms: Grant of 300 RSUs approved by Board on January 15, 2008 and communicated to CEO on January 16, 2008 RSUs convert into shares based on EPS performance during each fiscal year, whereby targets are established at the beginning of each fiscal year. Each tranche contains 100 units, however, service must be provided through March 1, 2011 to earn all 300 units. 2008 Target EPS 2009 Target EPS 2010 Target EPS < $0.25 Payout as % of Target Shares $0.25 - $0.29 50% $0.30 - $0.34 TBD on or near January TBD on or near January 10, 2009 10, 2010 100% $0.35 - $0.39 150% > $0.39 200% 0% Application of Guidance: Equity instrument with three tranches (Graded / FIN 28 amortization required). Performance condition governs quantity of instruments earned; service condition governs timing of vesting. 3 distinct grant dates; only tranche one is assigned a grant date when the award is granted (January 15, 2008). Service inception date will equal the grant date for each tranche. 7 2008 Equity Methods - Proprietary & Confidential

Case 2 Cash-settled SAR Cash-settlement feature: Grant of 100 stock appreciation rights awarded and communicated on March 15, 2008. 4-year annual graded vesting and 10-year contractual term. Upon the exercise of a SAR, a Grantee shall be entitled to receive an amount in cash equal to the excess of the fair market value of one share over the Exercise Price per share specified in the related SAR Grant, multiplied by the number of shares in respect of which the SAR Grant is exercised. Application of Guidance: Liability instrument. Service condition governs both timing of vesting and quantity of instruments earned. Four tranches (choice of attribution method, provided the method is applied consistently). One grant date (March 15, 2008) equal to service inception date. 8 2008 Equity Methods - Proprietary & Confidential

Compensation Expense Recognition 9 2008 Equity Methods - Proprietary & Confidential

Market / Performance Awards Create Multiple Outcomes Market and performance conditions differ from service conditions by creating the possibility of multiple outcomes. For example: If EPS growth exceeds 20%, vesting occurs in 2 years; otherwise vesting occurs in 8 years. If total shareholder return (TSR) is in the 90 th or greater percentile relative to peer firms, 150% of the target shares are earned; if in the 60 th 89 th percentile 100% of the target shares are earned; if below, 50% of the target shares are earned. If cumulative sales over the three year performance period exceed $35B, the units vest; upon vesting, units convert to shares based on TSR relative to the S&P 500. If TSR is in the 50 th or greater percentile, units convert at a ratio of 2.0; otherwise units convert at a ratio of 1.0. And so on 10 2008 Equity Methods - Proprietary & Confidential

Number of Iterations Accounting for a Market Condition Established and accepted theory exists for modeling the distribution of stock prices. Simulate all possible paths the stock may take over the life of the award. Embed economic effect of the market condition into each path. Aggregate the simulated paths to arrive at a single grant-date fair value that reflects market condition. As a result, amortization avoids need for variable accounting. 700 600 500 400 300 200 100 0 < 0 0-10 10-30 30-60 60-100 100-200 > 200 Simple market-based award design Payout depends on company performance versus S&P 500 Award Payouts ($) 11 2008 Equity Methods - Proprietary & Confidential

Accounting for a Performance Condition While the valuation of an award with a performance condition is generally straight-forward, the accounting model requires continuous assessments of the likely ( probable ) outcome. Often, the number of potential outcomes is very large, giving rise to frequent changes to estimated outcomes. Each time a new outcome is determined probable, adjustments are required within the accrual process. Is the reporting framework for a performance condition preferable to that of a market condition? Need to weigh: Volatility generated by performance conditions Stickiness generated by market conditions Is the objective a stable recognition pattern or one that matches the performance outcome achieved? Does it or should it even matter? 12 2008 Equity Methods - Proprietary & Confidential

Making Market Condition Valuations Strategic Understanding how valuation theory is applied reduces surprises and enables better up-front planning When awards are designed, quick and dirty valuations are often performed that are not audit proof. Awards should be designed with direct consideration of their expected cost to avoid surprises and plan better. Does each design feature generate sufficient incentive/motivation given its contribution to award cost? From a valuation perspective, there are three primary cost drivers: Payout Scale Firm Volatilities Firm Correlations Fair Value Large number of high payout opportunities Higher volatility relative to volatilities of peer firms/index Low correlation of stock price returns with peer firms/index Fair Value Low number of high payout opportunities Lower volatility relative to volatilities of peer firms/index High correlation of stock price returns with peer firms/index 13 2008 Equity Methods - Proprietary & Confidential

Cumulative effect versus prospective adjustments Partial cancellation Being Careful with Performance Conditions The amortization process required for performance conditions is a story of moving parts. A robust, flexible, and controlled amortization process is essential to long-term reporting success. The model is the amortization platform itself: a robust solution not only provides for accurate and consistent results, but also the ability to forecast the magnitude, volatility, and direction of future expense. Pools of distinct awards Contingently issuable shares Successive service inception dates Combinations of market and performance conditions Forfeiture rates Grant date vs Service Inception Date Mark-to-market valuation prior to occurrence of grant date 14 2008 Equity Methods - Proprietary & Confidential

FIN 28 / Graded Amortization Method Especially when dealing with performance awards, use of the FIN 28 / graded attribution method may not be synonymous with accelerated vesting. Recall Case 1: From a FAS 123R perspective, the award contains three grant dates (and thus fair values) Grant date cannot occur until all the terms are set Assume: 90 RSUs $50 fair value 3 tranches SID $500 $500 $500 SID $750 $750 $1,500 SCD SCD SID = Service Inception Date SCD = Service Completion Date SID SCD Year 1 Year 2 Year 3 $500 $1,250 $2,750 15 2008 Equity Methods - Proprietary & Confidential

Catch-Up Adjustments Two general cases required outside the handling of forfeitures and forfeiture rates: Liability awards remeasurement of fair value Performance conditions matching accruals to current probable outcome (which may change) Using Tranche 1 of Case 1 as an example (performance condition case): Revenue Target Payout Percentage < $0.25 $0.25 - $0.29 $0.30 - $0.34 $0.35 - $0.39 > $0.39 0% 50% 100% 150% 200% Start by evaluating each possible outcome: Recall 100 units granted in the tranche: 1 2 3 4 5 100 0% = 0 shares 100 50% = 50 shares 100 100% = 100 shares 100 150% = 150 shares 100 200% = 200 shares Each period, assess probable outcome and base expense on this outcome In reality, linear interpolation is applied for performance estimates or actual outcomes between established bands 16 2008 Equity Methods - Proprietary & Confidential

Catch-Up Adjustments (cont.) Let s walk through time, first noting that: Requisite service period is 38 months (Jan 1, 2008 Mar. 1, 2011) Fair value is $75 and forfeiture rate is 0% Quarter ending: 6/30/08 12/31/08 9/30/09 12/31/10 Performance outcome expected Outcome # 3 (100% payout) Outcome # 2 (50% payout) Outcome # 4 (150% payout) Outcome # 5 (200% payout) Corresponding accrual quantity 100 shares 50 shares 150 shares 200 shares Curr Period Expense Recognized before Catch-up Adjustment (100) ($75) ( 3 / 38 ) = $592 (50) ($75) ( 3 / 38 ) = $296 (150) ($75) ( 3 / 38 ) = $888 (100) ($75) ( 3 / 38 ) = $1,184 Prior Periods Since Beginning of Performance Period 0 quarters 2 quarters 5 quarters 12 quarters Catch-up Adjustment [Cum exp would have been recognized per current outcome LESS Cum exp recog per prior outcome] n/a [50 $75 2 ( 3 / 38 )] [100 $75 2 ( 3 / 38 )] = $592 [150 $75 5 ( 3 / 38 )] [50 $75 5 ( 3 / 38 )] = $2,960 [200 $75 12 ( 3 / 38 )] [150 $75 12 ( 3 / 38 )] = $3,553 17 2008 Equity Methods - Proprietary & Confidential

Deferred Tax Accounting 18 2008 Equity Methods - Proprietary & Confidential

Introduction to Deferred Tax Accounting Statement of Financial Accounting Standards 109 (FAS 109) governs the treatment of economic events whose accounting treatment is different (timing and/or amount) under financial accounting principles (GAAP) and Internal Revenue Service (IRS) rules. Examples include: Timing difference: revenue recognition Amount difference: expensing of meals These timing and / or amount mismatches result in either: Temporary difference (per Paragraph 4, FAS 109): a. Revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized in financial income b. Other events that create differences between the tax bases of assets and liabilities and their amounts for financial reporting c. Operating loss or tax credit carrybacks for refunds of taxes paid in prior years and carryforwards to reduce taxes payable in future years Permanent difference (per Paragraph 14, FAS 109): Certain basis differences may not result in taxable or deductible amounts in future years when the related asset or liability for financial reporting is recovered or settled and, therefore, may not be temporary differences for which a deferred tax liability or asset is recognized 19 2008 Equity Methods - Proprietary & Confidential

DTAs and DTLs A DTA is recognized for temporary differences that will result in deductible amounts in future years. In the context of share-based compensation instruments: Tax deduction at settlement Recognition of compensation expense during requisite service period Deferred Tax Asset A DTA is recorded as instrument vests. Upon settlement, it is reversed. Requisite service period Vesting Settlement A DTL is recognized for 83B elections to reflect the actual tax deduction preceding the recognition of compensation expense: Deferred Tax Liability A DTL is recorded at grant. It is reversed as the award is expensed. Requisite service period Settlement 20 2008 Equity Methods - Proprietary & Confidential

Determination of DTA Deferred tax asset tracks recognition of compensation expense. Recorded simultaneously with compensation expense Reflects the effect of a forfeiture rate DTA recorded in period = Compensation cost recognized in period Current statutory tax rate Changes in tax rates require true-up of the cumulative deferred tax asset Reverse DTA upon award forfeiture The challenge arises when the award is settled. To understand the challenge consider a different form of temporary difference: revenue recognition on long-term construction projects. Case facts: Result is: Total value $9,000,000 to be earned over 3-year construction period Builder is paid in full upon execution of contract prior to construction Taxable income in year 1 = $9,000,000. Book income in years 1 3 = $3,000,000 each year. By end of year three, temporary difference is eliminated: book income and taxable income are equal for this project. What makes this case so simple? 21 2008 Equity Methods - Proprietary & Confidential

Settlement Calculations for DTA At settlement, the temporary difference is eliminated because the taxable event occurs under both tax rules and GAAP, the award is recorded as compensation cost. But was there agreement as to the value of that compensation cost between GAAP and IRS rules? GAAP measurement basis: Fair value at grant (for equity awards) reflecting use of a valuation model IRS measurement basis: Intrinsic value at settlement These values will rarely agree! 22 2008 Equity Methods - Proprietary & Confidential

Settlement Calculations for DTA (cont.) Two cases: Windfall: Actual tax benefit exceeds deferred tax asset recorded. Debit Taxes Payable $20 Debit a liability to reduce its balance. Credit Deferred Tax Asset $15 Credit an asset to reduce its balance. Credit Additional Paid-in-Capital $5 Credit equity account to increase its balance. Shortfall: Deferred tax asset recorded exceeds actual tax benefit. Debit Taxes Payable $10 Debit a liability to reduce its balance. Debit Additional Credit Deferred Paid-in-Capital Tax Asset $15 $25 Credit Debit an equity asset to account reduceto its reduce balance. its balance. Credit Deferred Tax Asset $25 Credit an asset to reduce its balance. WAIT! This is not always permitted 23 2008 Equity Methods - Proprietary & Confidential

Shortfalls and APIC Pool Have we said anything about the APIC Pool yet? NO! Shortfalls (cases where the deferred tax asset recorded exceeds the actual tax benefit) are not intended to perpetually be pushed through additional paid-in-capital such that they never hit the income statement. Conceptually, shortfalls should be viewed as a drain on income. As compensation cost was recorded during the vesting period, it was reduced by the DTA amount. Remember: net income and taxable income are different. But it also may not make sense to reduce earnings for every shortfall that occurs. The APIC Pool is a buffer. Provides a way of transferring or using prior windfalls to cancel out current shortfalls. Cumulative tracking pool of net-windfalls. As a cumulative pool, its initial development required computing windfalls and shortfalls from settlements dating back to 1994 as if the company had been applying the fair value provisions of Statement 123. When the pool runs out, shortfalls are charged to earnings instead of reducing additional paid-in-capital. 24 2008 Equity Methods - Proprietary & Confidential

Advanced Topics: APIC vs. APIC Pool Debiting/crediting additional paid-in-capital is not the same as increasing/decreasing the APIC Pool. Additional paid-in-capital (APIC) is a balance sheet account. APIC Pool is an off balance sheet tracking pool used to determine whether, in cases of shortfalls, the company should decrease (debit) additional paid-in-capital OR charge the shortfall to earnings. Need to understand difference between Book DTA and Pro Forma DTA: Book DTA: compensation cost recognized in financial statements applicable tax rate. Pro forma DTA: compensation cost disclosed in footnotes per FAS 123 applicable tax rate. Increase/decrease to APIC Pool: Two methods for computing: short-cut method and long-form method. Choice of method yields different results and impacts ongoing accounting for increases/decreases to pool. If elected long-form method: Compute increases/decreases to APIC Pool by comparing actual tax benefit to book DTA and pro forma DTA. If elected short-cut method: For fully-vested awards at adoption, when computing their increase/decrease to the APIC Pool compare actual tax benefit to only book DTA pro forma DTA is ignored. Debit/Credit to APIC: always compare actual tax benefit to book DTA. 25 2008 Equity Methods - Proprietary & Confidential

Advanced Topics: Realization Requirement Footnote 82 of FAS 123R: the tax benefit and credit to APIC should only be recorded when the company can realize the tax deduction (deduction reduces taxes payable). Particularly complex when a company has taxable income but a greater amount of deductions and NOL carryforwards to offset this income. Which comes first? With-and-without policy: count tax deduction from option settlements last (ahead of NOL carryforwards). Tax law ordering: count tax deduction from option settlements first (ahead of NOL carryforwards). Serious tracking implications result: Prior tax deductions (and associated credit to APIC) that were frozen because they were not realized. Partial use of these tax deductions when only a portion are needed to reduce taxes payable to zero. 26 2008 Equity Methods - Proprietary & Confidential

Diluted Earnings per Share 27 2008 Equity Methods - Proprietary & Confidential

Overview of FAS 128 Basic EPS Earnings / Shares Issued & Outstanding (Common Stock) Weight Shares Issued During Period Diluted EPS Earnings / Shares Issued & Outstanding + Potential Common Stock ( Common Equivalents ) Potential common stock Dilutive effect on common stock outstanding Options / Restricted Stock / ESPP Shares Other dilutive securities (e.g., convertible debt) Objective of Diluted EPS Warning signal? Predictor of expected dilution? NO! Consistent with basic EPS, but give effect to all dilutive potential common shares Primary earnings per share arbitrary eliminated! 28 2008 Equity Methods - Proprietary & Confidential

Treasury Stock Method Why the treasury stock method? White Zinfandel How the treasury stock method works: Assume all in-the-money awards are vested and exercised at the beginning of period. Weight awards granted, exercised, or canceled during period to reflect period of time they were outstanding. Hypothetical exercise event generates proceeds to existing shareholders not entirely zero-sum Proceeds are used to repurchase shares at average market price during the period. Mitigates dilutive effect of potential common shares. The treasury stock method is modeling a hypothetical share buyback process that mitigates potential dilution. 29 2008 Equity Methods - Proprietary & Confidential

Assumed Proceeds Sources of assumed proceeds and key issues associated with each: 1. Exercise proceeds No exercise proceeds associated with SARs or restricted stock. 2. Unrecognized compensation cost Should not incorporate a forfeiture rate. Weighted over the period: better to use daily weighting versus beginning and ending average. 3. Excess tax benefit Realization requirement of FAS 123R. Credit to additional paid-in-capital only when tax benefit realizable (no NOLs). Tax deficiency with insufficient credits in APIC pool. Rather than resulting in a reduction to additional paid-in-capital, such deficiencies are charged to income tax expense. Correspondingly, they also do not reduce assumed proceeds. Policy decision to include or exclude pro forma deferred tax asset in determination of excess tax benefit. If included, calculation resembles APIC pool computation. If excluded, calculation resembles balance sheet additional paid-in-capital computation. 30 2008 Equity Methods - Proprietary & Confidential

Incremental Dilutive Shares and Anti-Dilution Assumed proceeds are used to buyback the weighted average awards being hypothetically exercised. Buy shares back at average market price during period. Buyback shares = ($ Assumed proceeds) / ($ Average market price). What if buyback shares exceed weighted average awards being hypothetically exercised? Anti-dilutive cases. Do not count but disclose anti-dilutive shares. Two conditions for anti-dilution: ($ Assumed proceeds) / ($ Average market price) > Weighted awards outstanding Option is underwater. 31 2008 Equity Methods - Proprietary & Confidential

EITF 03-6-1 Applicable to companies granting share-based payment instruments with non-forfeitable dividends or dividend equivalent units. Key implications: Dividends or DEUs paid on awards that do vest (or are expected to vest) are participating securities and are accounted for using the two-class method. Measurement of instruments not expected to vest. In all reporting periods, measure quantity of instruments not expected to vest and deduct this quantity in determinations of distributed and undistributed earnings. Measure of instruments not expected to vest will reflect forfeited awards and awards that are still vesting but are expected to forfeit via application of a forfeiture rate. Measurement will change over time as actual forfeitures occur and if the forfeiture rate is changed. Measurement of forfeiture reversals and extent to which they are overstated. In reversing expense on a forfeited award, that expense reflects the grant-date present value of expected dividends. Some of those expected dividends have been paid and thus are not forfeited in conjunction with the award. For each forfeiture, it is necessary to compute dividends paid on the award that the employee is not returning to the company. This amount is subtracted from the total amount forfeited. 32 2008 Equity Methods - Proprietary & Confidential

Modification Accounting 33 2008 Equity Methods - Proprietary & Confidential

Primer on Modifications As defined in FAS 123R, a modification is any change to the terms of an award. In regard to complexity, not all modifications are created equal. Complexity largely depends on whether the modification creates INCREMENTAL COST. Understanding incremental cost (abstracting from underwater exchanges). Employee sells current asset back to the company for a different asset. This exchange may be value-for-value, value-destroying, or value-creating to the employee. This determination requires measuring the value of: Original award design immediately before modification ( Before Value ). Modified award design immediately after modification ( After Value ). Key requirement is that the measurement is of current cost grant date fair value is irrelevant. Date of grant Immediately before modification Immediately after modification 34 2008 Equity Methods - Proprietary & Confidential

Primer on Modifications (cont.) No negative incremental cost: When comparing the before value to the after value (called the Before and After Test ), the before value may exceed the after value, thus creating negative incremental cost. FAS 123R creates a floor by requiring that at least the grant-date fair value of the awards granted be expensed. If negative incremental cost, continue recognizing expense on the original grant date fair value. Except when The original quantity of awards granted is not expected to vest. Consider an example: Original quantity of awards granted is 100 and grant-date fair value is $10 Immediately before modification: Quantity of awards expected to vest: 0 Fair value: $3 Immediately after modification: Quantity of awards expected to vest: 100 Fair value: $6 Correct treatment: post modification, base expense on $6 fair value and not the $10 fair value. 35 2008 Equity Methods - Proprietary & Confidential

Incremental Cost Example $ Net FV (FV c ) FV tied to Orig Grant (FV a ) At settlement, reconcile against net fair value (FV c = FV a + FV b ) Accrue expense on original grant date fair value (FV a ) over requisite service period of the grant (VD SD) FV tied to Inc Cost (FV b ) Accrue incremental cost (FV b ) from modification to vesting (VD MD) Service Inception Date (SD) Modificatio n Date (MD) Vesting Date (VD) Exercise Date (ED) t 36 2008 Equity Methods - Proprietary & Confidential

Types of Modifications Expected in 2009 Although numerous forms of modification are available, the following five are presumed to be most common. Value-for-Value Exchange Non-Value-for- Value Exchange Pure Repricing Post-Termination Exercise Window Acceleration of Vesting Tender offer to exchange underwater options for replacement options, RSUs, or cash (or a combination thereof). Requires a lattice model to value. Structured to avoid any incremental cost. Tender offer to exchange underwater options for replacement awards but intended to create incremental cost. Requires a lattice model to value. Structured to be more favorable to employee and drive participation (creates incremental cost). Pure alteration to the strike price to make the terms of options more favorable to employee. Requires a lattice model to value. Will result in incremental cost. Does not require a tender offer because no investment decision required. Extend posttermination exercise window for terminated employees holding vested options. Requires a lattice model to value. Will generate incremental cost. Accelerate vesting partially or fully on awards held by a terminated employee who would otherwise forfeit the awards. Type III modification under FAS 123R grantdate fair value not relevant. May or may not require use of a lattice model. 37 2008 Equity Methods - Proprietary & Confidential

Deciding to Modify Many modifications give rise to a spectrum of difficulties, ranging from securities law to accounting, from administration to employee retention. Stock Admin. Terms of stock plans Stock exchange rules In evaluating the different types of modifications, a useful process to follow is: Define your objectives Consider modification alternatives in light of those objectives HR / retention objectives Successful Modification Securities laws Assess end-to-end range of requirements (per the chart to the right) identify the gotchas Organize a project team, implement Ongoing financial reporting Stockholder relations Accounting objectives Tax laws 38 2008 Equity Methods - Proprietary & Confidential

Start by Considering Incremental Cost What is the desired outcome? Value for value? Employee compensation (pure retention/resetting of incentives)? Even if unsure, start by quantifying value-for-value. Were the modification to be accounting neutral, how would it be structured? Be sure to perform a FAS 123R-compliant valuation do not rely on pro forma estimates. Primary challenge is estimating expected term on an underwater option. Value-for-value is the yardstick Test the P&L implications associated with each deviation from value-for-value 39 2008 Equity Methods - Proprietary & Confidential

Small incremental expense Small incremental expense Large incremental expense Large incremental expense The Value-for-Value Principle The more underwater the options the less of a P&L impact a non-value-for-value exchange should have. Case A: Small Incremental Cost Resulting from Non-Value-for-Value Case B: Large Incremental Cost Resulting from Non-Value-for-Value Moderately Underwater Extremely Underwater Moderately Underwater Extremely Underwater 40 2008 Equity Methods - Proprietary & Confidential

Estimating Expected Term: Best Practice is to use a Lattice Model Valuing partially- or fully-vested underwater options requires different approaches than those used to value new at-the-money grants. Exp. term = 5 yrs 2 yrs 5.2 yrs Value is impacted by option being underwater AND the effect of this on exercise behavior. Exp term = 7.2 yrs At-themoney At-themoney = Valuation date Grant Expiration Grant Exchange Expiration 41 2008 Equity Methods - Proprietary & Confidential

Thinking through Systems Challenges Connecting the dots need to ensure that: Original expense (pre modification) is tied to replacement award and amortized over original service period. Policy option to amortize unamortized component of grant-date fair value over the modified vesting period. Not recommended (see next slide). Incremental cost associated with the replacement award (modification) amortized over modified service period. Amortize this amount prospectively no catch-up adjustment. Cumulative deferred tax asset reflects: Component of grant-date fair value expensed pre modification. Component of grant-date fair value expensed post modification. Incremental cost created by modification. Systems challenge involves manner in which grants are treated: Pre modification award canceled, post modification award (a.k.a., replacement award) created. Essential to be able to link and unlink these two grants: For expense recognition: need to separate components of expense because the timing of attribution varies by component. For deferred tax accounting: need to aggregate components because the cumulative deferred tax asset is used. 42 2008 Equity Methods - Proprietary & Confidential

Hidden Floor Provision When performing an option exchange, it is typical to extend the vesting. This can result in unexpected violations to the FAS 123R floor provision. Assume: 100 options valued at $5 exchanged for 50 RSUs valued at $10 Grant-date fair value of options $20 Original vesting schedule was 4 years Vesting revised so RSUs vest one year after modification (in year 5) Year 3 Year 4 Year 4.5 Year 5 Options exchanged; vesting extended 1 year Original vesting date Employee terminates, options forfeited Revised vesting date $1,500 expense recognized to date (¾ * $20 * 100) If amortizing on modified vesting schedule as of forfeiture date: $125 remaining expense. Forfeit $1,875 recognized expense. Wrong! Must continue amortizing according to original vesting schedule. However, EPS and DTA accounting are based on modified vesting schedule. 43 2008 Equity Methods - Proprietary & Confidential

Invitation to Equity Methods Webinar on Exchanges Our webinar on Friday, February 20, 2009 will provide an update on: Equity Methods experience supporting over 12 companies perform an exchange in the last few months. Equity Methods survey on actual company experience performing an exchange. Equity Methods database of all companies who have performed an exchange and the terms they selected. Please register at: www.equitymethods.com/news-events.html 44 2008 Equity Methods - Proprietary & Confidential

Parting Comments 45 2008 Equity Methods - Proprietary & Confidential

Parting Comments I. Various Forms of Share-Based Compensation. Informs the correct accounting treatment. Plan details matter. II. Compensation Expense Market and performance conditions Catch-up adjustments. Forfeiture adjustments. III. Deferred Taxes IV. Diluted Earnings per Share V. Modification Accounting and Exchanges Before / After Test: determination of incremental compensation cost. Application to various types of modifications. 46 2008 Equity Methods - Proprietary & Confidential

About the Speaker Takis Makridis Equity Methods Director, Professional Services tmakridis@equitymethods.com 480-237-3107 Speaker Biography Takis Makridis is the head of professional services at Equity Methods. Takis leverages extensive consulting experience in overseeing the consulting practice at Equity Methods while remaining active in the firm s research efforts. He works closely with finance and HR executives to address their valuation and financial reporting needs and is critically engaged with accounting and valuation thought-leaders from consulting firms, public accounting, and academia. He is a nationally recognized speaker at industry conferences across the country and frequently leads executive briefing sessions and firm webinars to enhance knowledge sharing among client firms and disseminate best practices throughout the industry. Takis is the author of Advanced Topics in Equity Compensation Accounting, published by the National Center for Employee Ownership, which is a required text for the Certified Equity Professional (CEP) designation. Takis holds a B.S. in Economics and Finance from Arizona State University and an M.B.A. from Oxford University. 47 2008 Equity Methods - Proprietary & Confidential