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feited because of failure to meet vesting requirements are excluded from determination of com- pensation cost. In certain circumstances, due to the terms of a stock option or other equity instrument, it may not be feasible to reasonably estimate the fair value of a stock-based award at the grant date. For example, the fair value of a stock option whose exercise price adjusts by a specified amount with each change in the underlying price of the stock cannot be reasonably estimated using an option pricing model. If the fair value cannot be estimated at the grant date, fair value at the first date at which it is possible to reasonably estimate that value should be used as the final measure of compensation cost. For interim periods during which it is not possible to de- termine fair value, companies should estimate compensation cost based on the current intrinsic value of the award. 37.6 APPLICATION OF FASB STATEMENT NO. 123 37 • 41 COMPARISON OF COMPENSATION COST RECOGNIZED UNDER FASB STATEMENT NO. 123 AND APB OPINION NO. 25 Assume the following for stock compensation awards made by Company A, a public company: Stock price at date of grant (January 1, 2000) $40 Expected life of options 6 years Risk-free interest rate 7.0% Expected volatility in stock price 30% Expected dividend yield 1.5% Vesting schedule for options 100% at end of third year Options expected to vest (5,000 forfeited each year) 285,000 Estimated fair value of each option* $15 Stock price at December 31, 2002 $60 *Fair value calculated using an acceptable pricing model. Fixed Stock Option Award On January 1, 2000, Company A grants 300,000 stock options to officers and other employees with a maximum term of 10 years and an exercise price equal to the market price of the stock at date of grant. APB Opinion 25 FASB Statement No. 123 Compensation cost recognized: Year 2000 $0,000,000 $1,425,000 Year 2001 0 1,425,000 Year 2002 $0,000,000 $1,425,000 Total $0,000,000 $4,275,000 Performance Stock Award On January 1, 2000, Company A also grants 30,000 restricted shares to certain employees. The restrictions lapse at the end of three years if certain annual earnings per share targets are met during the three-year period. For purposes of this example, assume the earnings per share targets were met during the three-year period and the restrictions lapsed on December 31, 2002. APB Opinion 25 FASB Statement No. 123 Compensation cost recognized $1,800,000 $1,200,000 Exhibit 37.7 Comparison of compensation cost recognized under FASB Statement No. 123 and APB Opinion No. 25. (d) OPTION PRICING MODELS. In addressing the issue of estimating fair value of equity instruments, the FASB noted that it was not aware of any quoted market prices that would be appropriate for employee stock options. Accordingly, FASB Statement No. 123 requires that the fair value of a stock option (or its equivalent) be estimated using an option-pricing model, such as the Black-Scholes or a binomial pricing model, that considers the following assump- tions or variables: • Exercise price of the option. • Expected life of the option—Considers the outcome of service-related conditions (i.e., vesting requirements and forfeitures) and performance-related conditions. Expected life is typically less than the contractual term. • Current price of the underlying stock—Stock price at date of grant. • Expected volatility of the underlying stock—An estimate of the future price fluctuation of the underlying stock for a term commensurate with the expected life of the option. Volatility is not required for nonpublic companies. • Expected dividend yield on the underlying stock—Should reflect a reasonable expectation of dividend yield commensurate with the expected life of the option. • Risk-free interest rate during the expected term of the option—The rate currently available for zero-coupon U. S. government issues with a remaining term equal to the expected life of the options. FASB Statement No. 123 requires that the option pricing model utilized consider manage- ment’s expectations relative to the life of the option, future dividends, and stock price volatility. Both the volatility and dividend yield components should reflect reasonable expectations com- mensurate with the expected life of the option. As there is likely to be a range of reasonable ex- pectations about factors such as expected volatility, dividend yield, and lives of options, a company may use the low end of the range for expected volatility and expected option lives and the high end of the range for dividend yield (assuming that one point within the ranges is no better estimate than another). These estimates introduce significant judgments in determining the value of stock-based compensation awards. During the FASB’s discussions prior to issuance of FASB Statement No. 123, those favoring re- tention of the basic requirements of APB Opinion No. 25 emphasized the imprecision of measuring fair value through option pricing models, particularly in light of the fact that most stock options is- sued to employees are not transferable and are forfeitable. The Board believes that it has addressed these issues by valuing at zero options that are expected to be forfeited, and by valuing options that vest based on the length of time they are expected to remain outstanding rather than on the stated term of the options. During the last 20 years, a number of mathematical models for estimating the fair value of traded options have been developed. The most commonly used methodologies for valuing options include the Black-Scholes model, binomial pricing models, and the minimum value method. The minimum value of a stock option can be determined by a simple present value calculation which ignores the ef- fect of expected volatility. (See Exhibit 37.8 for an illustration of the minimum value method.) The fair value of an option exceeds the minimum value because of the volatility component of an option’s value, which represents the benefit of the option holder’s right to participate in stock price increases without having to bear the risk of stock price decreases. The Black–Scholes and binomial pricing models were originally developed for valuing traded options with relatively short lives and are based on complex mathematical formulas. Option values derived under these models are sensitive to both the expected stock volatility and the expected dividend yield. Exhibit 37.8 illustrates the relative effect of changes in ex- pected volatility and dividend rates using a generalized Black-Scholes option-pricing model. Software packages that include option pricing models are readily available from numerous software vendors. 37 • 42 STOCK-BASED COMPENSATION As demonstrated in Exhibit 37.8, option values increase as expected volatility increases, and op- tion values decrease as expected dividend yield increases. It is interesting to note that in instances where higher expected volatility is coupled with higher dividend yields, the binomial model gener- ally produces higher option values than the Black-Scholes model due primarily to increased sensi- tivity to compounded dividend yields in the binomial model. Nevertheless, FASB Statement No. 123 permits the use of either model. (i) Expected Volatility. Volatility is the measure of the amount that a stock’s price has fluc- tuated (historical volatility) or is expected to fluctuate (expected volatility) during a specified period. Volatility is expressed as a percentage; a stock with a volatility of 25% would be ex- pected to have its annual rate of return fall within a range of plus or minus 25 percentage points of its expected rate about two-thirds of the time. For example, if a stock currently trades at $100 with a volatility of 25% and an expected rate of return of 12%, after one year the stock price should fall within the range of $87 to $137 approximately two-thirds of the time (using simple interest for illustration). Stocks with high volatility provide option holders with greater economic “up-side” potential and, accordingly, result in higher option values under the Black– Scholes and binomial option pricing models. FASB Statement No. 123 suggests that estimating expected future volatility should begin with calculating historical volatility over the most recent period equal to the expected life of the op- tions. Thus, if the weighted-average expected life of the options is six years, historical volatility should be calculated for the six years immediately preceding the option grant. FASB Statement No. 123 provides an illustrative example for calculating historical volatility. Companies should modify historical stock volatility to the extent that recent experience indicates that the future is reasonably expected to differ from the past. Although historical averages may be the best available indicator of expected future volatility for some mature companies, there are legitimate exceptions including: (1) a company whose common stock has only recently become publicly traded with lit- tle, if any, historical data on its stock price volatility, (2) a company with only a few years of pub- lic trading history where recent experience indicates that the stock has generally become less volatile, and (3) a company that sells off a line of business with significantly different volatility than the remaining line of business. In such cases, it is appropriate for companies to adjust histor- ical volatility for current circumstances or use the average volatilities of similar companies until a longer series of historical data is available. 37.6 APPLICATION OF FASB STATEMENT NO. 123 37 • 43 ESTIMATED OPTION VALUES Assumptions: Exercise price—$40 (equals current price of underlying stock) Expected dividends—0%, 2%, and 4% Expected risk-free rate of return—7% Expected volatility—0%, 20%, 30%, and 40% Expected term—six years Fair values calculated using a Black-Scholes option pricing model Volatility Dividend Rate 0% 20% 30% 40% 0% $13.35 $15.14 $17.56 $20.16 2% 8.87 11.42 13.98 16.57 4% 4.96 8.45 11.05 13.58 Exhibit 37.8 Estimated option values. FASB Statement No. 123 does not allow for a company with publicly traded stock to ignore volatility simply because its stock has little or no trading history. A company with only publicly traded debt is not considered a public company under FASB Statement No. 123. Subsidiaries of public companies are considered public companies for purposes of applying FASB Statement No. 123’s provisions. (ii) Expected Dividends. The assumption about expected dividends should be based on publicly available information. While standard option pricing models generally call for expected dividend yield, the model may be modified to use an expected dividend amount rather than a yield. If a com- pany uses expected payments, any history of regular increases in dividends should be considered. For example, if a company’s policy has been to increase dividends by approximately 3% per year, its estimated option value should not assume a fixed dividend amount throughout the expected life of the option. Some companies with no history of paying dividends might reasonably expect to begin paying small dividends during the expected lives of their employee stock options. These com panies may use an average of their past dividend yield (zero) and the mean dividend yield of an appropriately comparable peer group. (iii) Expected Option Lives. The expected life of an employee stock option award should be es- timated based on reasonable facts and assumptions on the grant date. The following factors should be considered: (1) the vesting period of the grant, (2) the average length of time similar grants have re- mained outstanding, and (3) historical and expected volatility of the underlying stock. The expected life must at least include the vesting period and, in most circumstances, will be less than the contrac- tual life of the option. Option value increases at a higher rate during the earlier part of an option term. For example, a two-year option is worth less than twice as much as a one-year option if all other assumptions are equal. As a result, calculating estimated option values based on a single weighted-average life that includes widely differing individual lives may overstate the value of the entire award. Companies are encouraged to group option recipients into relatively homogeneous groups and calculate the related option values based on appropriate weighted-average expectations for each group. For example, if top level executives tend to hold their options longer than middle management, and nonmanagement employees tend to exercise their options sooner than any other groups, it would be appropriate to stratify the employees into these three groups in calculating the weighted-average estimated life of the options. (iv) Minimum Value Method. FASB Statement No. 123 indicates that a nonpublic company may estimate the value of options issued to employees without consideration of the expected volatility of its stock. This method of estimating an option’s value is commonly referred to as the minimum value method. The underlying concept of the minimum value method is that an individual would be will- ing to pay at least an amount that represents the benefit of the right to defer payment of the exercise price until a future date (time value benefit). For a dividend-paying stock, that amount is reduced by the present value of dividends forgone due to deferring exercise of the option. Minimum value can be determined by a present value calculation of the difference between the current stock price and the present value of the exercise price, less the present value of expected divi- dends, if any. Minimum value also can be computed using an option-pricing model and an expected volatility of effectively zero. Although the amounts computed using present value techniques may produce slightly different results than option-pricing models for dividend-paying stocks, the Board decided to permit either method of computing minimum value. Exhibit 37.9 illustrates a minimum value computation for an option, assuming an expected five- year life with an exercise price equal to the current stock price of $40, an expected annual dividend yield of 1.25%, and a risk-free interest rate available for five-year investments of 6%. The FASB Statement No. 123 does not allow public companies to account for employee stock options based on the minimum value method because that approach was considered 37 • 44 STOCK-BASED COMPENSATION inconsistent with the overall fair value concept. However, the FASB acknowledged that esti- mating expected volatility for the stock of nonpublic companies is not feasible. Accordingly, FASB Statement No. 123 permits nonpublic companies to ignore expected volatility in esti- mating the value of options granted. As a result, nonpublic entities are allowed to use the min- imum value method for stock options issued to employees. However, during the EITF’s discussion of EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” an FASB staff representative stated that when applying the consensuses in that Issue, the minimum value method is not an acceptable method for determining the fair value of nonemployee awards by nonpublic companies. (e) RECOGNITION OF COMPENSATION COST. As previously discussed, FASB Statement No. 123 requires either recognition of compensation cost in an employer’s financial statements for those companies adopting the new standard or disclosure of pro forma net income and earnings per share for companies remaining under APB Opinion No. 25 for all awards of stock options and other stock-based instruments. FASB Statement No. 123 applies the same basic accounting principles to all stock-based plans, including those currently considered noncompensatory under APB Opinion No. 25. At the date of grant, compensation cost is measured as the fair value of the total number of awards expected to vest. Adjustments to the amount of compensation cost recognized should be made for ac- tual experience in performance and service-related factors (i.e., forfeitures, attainment of performance goals, etc.). Changes in the price of the underlying stock or its volatility, the life of the option, divi- dends on the stock, or the risk-free interest rate subsequent to the grant date do not adjust the fair value of options or the related compensation cost. A stock option for which vesting or exercisability is conditioned upon achievement of a targeted stock price or specified amount of intrinsic value does not constitute a performance award for which compensation expense would be subsequently adjusted. For awards that incorporate such features, compensation cost is recognized for employees who remain in service over the service period re- gardless of whether the target stock price or amount of intrinsic value is reached. FASB Statement No. 123 does indicate, however, that a target stock price condition generally affects the value of such options. Previously recognized compensation cost should not be reversed if a vested employee stock option expires unexercised. Awards for past services would be recognized as a cost in the period the award is granted. Compensation expense related to awards for future services would be recognized over the pe- riod the related services are rendered by a charge to compensation cost and a corresponding credit to equity (paid-in capital). Unless otherwise defined, the service period would be con- sidered equivalent to the vesting period. Vesting occurs when the employee’s right to receive the award is not contingent upon performance of additional services or achievement of a spec- ified target. 37.6 APPLICATION OF FASB STATEMENT NO. 123 37 • 45 MINIMUM VALUE METHOD Current stock price $40.00) Less: Present value of exercise price (29.89) Present value of expected dividends 0(2.11) Minimum value of option 1 $08.00) 1 The $8.00 minimum value was determined by a present value calculation. By way of contrast, applica- tion of a Black–Scholes option-pricing model results in a minimum value of $7.70. Exhibit 37.9 Minimum value computation. Compensation cost for an award with a graded vesting schedule should be recognized in accor- dance with the method described in FASB Interpretation 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans,” if the fair value of the award is determined based on different expected lives for the options that vest each year, as it would be if the award is viewed as several separate awards, each with a different vesting date. However, if the value of the award is determined based on a composite expected life, or if the award vests at the end of a period (i.e., cliff vesting), the related compensation cost may be recognized on a straight-line basis over the service period, presumed to be the vesting period. FASB Statement No. 123 does require that the amount of compensation cost recognized at any date must at least equal the value of the vested por- tion of the award at that date. FASB Statement No. 123 requires that dividends or dividend equivalents paid to employees on the portion of restricted stock or other equity award that is not expected to vest be recognized as ad- ditional compensation cost during the vesting period. Also, certain awards provide for reductions in the exercise or purchase price for dividends paid on the underlying stock. In these circumstances, FASB Statement No. 123 requires use of a dividend yield of zero in estimating the fair value of the related award. This provision would have the effect of increasing the fair value of a stock option on a dividend-paying stock. (f) ADJUSTMENTS OF INITIAL ESTIMATES. Measurement of the value of stock options at grant date requires estimates relative to the outcome of service- and performance-related conditions. FASB Statement No. 123 adopts a grant date approach for stock-based awards with service require- ments or performance conditions and specifies that resulting compensation cost should be adjusted for subsequent changes in the expected or actual outcome of these factors. Subsequent adjustments would not be made to the original volatility, dividend yield, expected life, and interest rate assump- tions or for changes in the price of the underlying stock. Exhibit 37.10 illustrates the impact on com- pensation cost when actual forfeitures resulting from terminations deviate from the rate anticipated at grant date. A performance requirement adds another condition that must be met in order for employees to vest in certain awards, in addition to rendering services over a period of years. Compensa- tion cost for these awards should be recognized each period based on an assessment of the probability that the performance-related conditions will be met. Those estimates should be subsequently adjusted to reflect differences between expectations and actual outcomes. The cu- mulative effect of such changes in estimates on current and prior periods should be recognized in the period of change. 37 • 46 STOCK-BASED COMPENSATION ADJUSTMENT OF FORFEITURE RATE UNDER FASB STATEMENT NO. 123 Assumptions: Options granted 10,000) Vesting schedule 100% at end of third year (cliff vesting) Estimated forfeiture rate 6% per year (upon termination) Actual forfeiture rate 6% in years 1 and 2; 3% in year 3 Option value at grant date $10) Estimated fair value of award at grant date: (10,000 ϫ .94 ϫ .94 ϫ .94) ϫ $10 ϭ $83,100) Compensation cost recognized in years 1 and 2: $83,100 Ϭ 3 ϭ $27,700) Compensation cost recognized in year 3 (3% forfeiture rate): Total compensation cost to be recognized: (10,000 ϫ .94 ϫ .94 ϫ .97) ϫ $10 ϭ $85,700) Cost recognized in year 1 (27,700) Cost recognized in year 2 (27,700) Cost recognized in year 3 $30,300) Exhibit 37.10 Adjustment of forfeiture rate under FASB Statement No. 123. (g) MODIFICATIONS TO GRANTS. FASB Statement No. 123 requires that a modification to the terms of an award that increases the award’s fair value at the modification date be treated, in sub- stance, as the repurchase of the original award in exchange for a new award of greater value. Addi- tional compensation cost arising from a modification of a vested award should be recognized for the difference between the fair value of the new award at the modification date and the fair value of the original award immediately before its terms are modified, determined based on the shorter of (a) its remaining expected life or (b) the expected life of the modified option. For modifications of non- vested options, compensation cost related to the original award not yet recognized must be added to the incremental compensation cost of the new award and recognized over the remainder of the em- ployee’s service period. As an example of a modification of a vested option, assume that, on January 1, 2000, Com- pany A granted its employees 300,000 stock options with an exercise price of $50 per share and a contractual term of 10 years. The options vested at the end of three years and 15,000 of the original 300,000 options were forfeited prior to vesting. On January 1, 2004, the market price of Company A stock has declined to $40 per share, and Company A decides to reduce the exercise price of the options. Under FASB Statement No. 123, Company A has effectively issued new options and would recognize additional compensation cost as a result of the reduc- tion in exercise price. The estimated fair value of the original award at the modification date would be determined using the assumptions for dividend yield, volatility, and risk-free interest rate at the modification date. Exhibit 37.11 illustrates the measurement of additional compen- sation cost upon modification of the terms of this award. In certain cases, modifications may be made to options that were granted before FASB State- ment No. 123 was effective. Under APB Opinion No. 25, compensation cost would not have been 37.6 APPLICATION OF FASB STATEMENT NO. 123 37 • 47 MODIFICATIONS TO GRANTS UNDER STATEMENT FASB NO. 123 Assume the following for stock options granted and subsequently modified by Company A, a public company: Fair Value of Fair Value of Fair Value of Original Award New Award Original Award January 1, 2000 January 1, 2004 January 1, 2004 Exercise price $50 $40 $50 Stock price $50 $40 $40 Expected volatility 30% 35% 35% Expected dividend yield 1.5% 2.0% 2.0% Expected option life 6 years 5 years 2 years 1 Risk-free interest rate 6.5% 5.75% 5.75% Estimated fair value of each option 2 $18 $13 $05 1 Lesser of remaining expected life of original award or expected life of new award. 2 Fair value calculated using an acceptable pricing model. The computation of additional compensation cost resulting from this modification would be as follows: Estimated fair value of new award ($13/option ϫ 285,000) $(3,705,000) Estimated fair value of original award at modification date ($5/option ϫ 285,000) (1,425,000) Incremental compensation cost of new award $(2,280,000) Because the award is fully vested at the modification date, the additional compensation cost of $2,280,000 would be expensed in the period of modification. Exhibit 37.11 Modifications to grants under FASB Statement No. 123. recognized upon initial issuance of an option if the exercise price was equal to the market price on the grant date. Because no compensation cost was recognized for the original options, the modified options are treated as a new grant. For modifications of vested options, compensation cost is recog- nized immediately for the fair value of the new option on the modification date. However, if the op- tions had intrinsic value on the modification date (i.e., the options were in the money), the intrinsic value would be excluded from the amount of compensation cost recognized because an employee could have exercised the options immediately before the modification and received the intrinsic value without affecting the amount of compensation cost recognized by the company. For modifi- cations to nonvested options, previously unrecognized compensation cost, if any, is added to incre- mental compensation cost from the new award and recognized over the employee’s service period. Exchanges of options or changes in their terms in conjunction with business combinations, spin-offs, or other equity restructurings are considered modifications under FASB Statement No. 123, with the exception of those changes made to reflect the terms of the exchange of shares in a business combination accounted for as a pooling of interests. This represents a change in practice, as such modifications do not typically result in a new measurement date under APB Opinion No. 25, and, therefore, additional compensation expense is not recorded. However, changing the terms of an award in accordance with antidilution provisions that are designed, for example, to equalize an option’s value before and after a stock split or a stock dividend is not considered a modification. (h) OPTIONS WITH RELOAD FEATURES. Reload stock options are granted to employees upon exercise of previously granted options whose original terms provide for the use of “mature” shares of stock that the employee has owned for a specified period of time (generally six months) rather than cash to satisfy the exercise price. When an employee exercises the original options using mature shares (a stock for stock exercise), the employee is automatically granted a reload option for the same number of shares used to exercise the original option. The exercise price of the reload option is the market price of the stock at the date the reload option is granted, and the term is equal to the remain- der of the term of the original option. Compensation cost related to options with reload features should be calculated separately for the initial option grant and each subsequent grant of a reload option. In the Basis for Conclusions (Appendix A to FASB Statement No. 123), the FASB states its belief that, ideally, the value of an option with a reload feature should be estimated at the grant date, taking into account all of its features. However, the Board concluded that it is not feasible to do so because no reasonable method currently exists to estimate the value added by a reload feature. Accordingly, the Board decided that compensation cost for an option with a reload feature should be calculated separately for the initial option grant and for each subsequent grant of a reload option as if it were a new grant. (i) SETTLEMENT OF AWARDS. Employers occasionally repurchase vested equity instruments issued to employees for cash or other assets. Under FASB Statement No. 123, amounts paid up to the fair value of the instrument at the date of repurchase should be charged to equity, and amounts paid in excess of fair value should be recognized as additional compensation cost. For example, a com- pany that repurchases a vested share of stock for its market price does not incur additional compen- sation cost. A company that settles a nonvested award for cash has, in effect, vested the award, and the amount of compensation cost measured at the grant date and not yet recognized should be recog- nized at the repurchase date. A repurchase of vested stock options would be treated in a manner similar to a modification of an option grant. Incremental compensation cost, if any, to be recognized upon cash settlement should be determined as the excess of cash paid over the fair value of the option on the date the employee ac- cepts the repurchase offer, determined based on the remainder of its original expected life at that date. Additionally, if unvested stock options are repurchased, the amount of previously unrecognized compensation cost should be recognized at the repurchase date because the repurchase of the option effectively vests the award. Exhibit 37.12 illustrates the accounting for the repurchase of an award by the employer. 37 • 48 STOCK-BASED COMPENSATION In certain circumstances, awards granted prior to adoption of FASB Statement No. 123 may be set- tled in cash subsequent to adoption of FASB Statement No. 123. Compensation cost would not have been recognized for the original award under APB Opinion No. 25 if the exercise price equaled the market price on the grant date. Because no cost was previously recognized for the original award, the cash settlement of the vested options is treated as a new grant and recognized as compensation cost on the repurchase date. However, if the original options had been in-the-money and thus had intrinsic value immediately before the settlement, the intrinsic value is excluded from compensation cost, sim- ilar to the accounting for a grant modification. (j) TANDEM PLANS AND COMBINATION PLANS. Employers may have compensation plans that offer employees a choice of receiving either cash or shares of stock in settlement of their stock- based awards. Such plans are considered tandem plans. For example, an employee may be given an award consisting of a cash stock appreciation right and an SAR with the same terms except that it calls for settlement in shares of stock with an equivalent value. The employee may demand settle- ment in either cash or in shares of stock and the election of one component of the plan (cash or stock) cancels the other. Because the employee has the choice of receiving cash, this plan results in the company incurring a liability. The amount of the liability will be adjusted each period to reflect the current stock price. If employees subsequently choose to receive shares of stock rather than receive cash, the liability is settled by issuing stock. If the terms of a stock-based compensation plan provide that settlement of awards to employees will be made in a combination of stock and cash, the plan is considered a combination plan. In a combination plan, each part of the award is treated as a separate grant and accounted for separately. The portion to be settled in stock is accounted for as an equity instrument and the cash portion is ac- crued as a liability and adjusted each period based on fluctuations in the underlying stock price. Exhibit 37.13 illustrates the accounting for an award expected to be settled in a combination of cash and stock. 37.6 APPLICATION OF FASB STATEMENT NO. 123 37 • 49 REPURCHASE OF AWARD UNDER FASB STATEMENT NO. 123 On January 1, 2000, Company A grants a total of 10,000 “at-the-money” options to employees. The options vest after three years and are exercisable through December 31, 2009. The market price of Company A stock is $50 at grant date. It is expected that a total of 8,500 options will vest, based on projected forfeitures. The fair value of an option at grant date is $18, using an acceptable option pricing model. At grant date, Company A would compute compensation cost of $153,000 (8,500 ϫ $18 per option) to be recognized ratably over the service period. On January 1, 2005, Company A repurchases 2,000 of the vested options for $30 per option. On that date, the market price of Company A’s stock is $60 and the option’s fair value is $24. Additional compensation cost would be recognized for the difference between the cash paid and the fair value of the option at the date of repurchase. Calculations: Repurchase price of options $30 Fair value of options at repurchase date 24 Additional compensation cost $06 ϫ 2,000 options ϭ $12,000 Journal entry: Compensation expense $12,000 Additional paid in capital 1 48,000 Cash $60,000 1 Fair value of options repurchased (2,000 ϫ $24) Exhibit 37.12 Repurchase of award under FASB Statement No. 123. (k) EMPLOYEE STOCK PURCHASE PLANS. Some companies offer employees the opportunity to purchase company stock, typically at a discount from market price. If certain conditions are met, the plan may qualify under Section 423 of the Internal Revenue Code, which allows employees to defer taxation on the difference between the market price and the discounted purchase price. APB Opinion No. 25 generally treats employee stock purchase plans that qualify under Section 423 as noncompensatory. Under FASB Statement No. 123, broad-based employee stock purchase plans are compensatory unless the discount from market price is relatively small. Plans that provide a discount of no more than 5% would be considered noncompensatory; discounts in excess of this amount would be con- sidered compensatory under FASB Statement No. 123 unless the company could justify a higher dis- count. A company may justify a discount in excess of 5% if the discount from market price does not exceed the greater of (a) the per-share discount that would be reasonable in a recurring offer of stock to stockholders or (b) the per-share amount of stock issuance costs avoided by not having to raise a significant amount of capital by a public offering. If a company cannot provide adequate support for a discount in excess of 5%, the entire amount of the discount should be treated as compensation cost. For example, if an employee stock purchase plan provides that employees can purchase the em- ployer’s common stock at a price equal to 85% of its market price as of the date of purchase, com- pensation cost would be based on the entire discount of 15% unless the discount in excess of 5% can be justified. If an employee stock purchase plan meets the following three criteria, the discount from market price is not considered stock-based compensation: 1. The plan incorporates no option features other than the following, which may be incorporated: (a) employees are permitted a short period of time (not exceeding 31 days) after the purchase price has been fixed in which to enroll in the plan, and (b) the purchase price is based solely on the stock’s market price at the date of purchase and employees are permitted to cancel par- ticipation before the purchase date. 37 • 50 STOCK-BASED COMPENSATION COMBINATION PLAN UNDER FASB STATEMENT NO. 123 Company A has a performance-based plan that provides for a maximum of 900,000 performance awards to be earned by participants if certain financial goals are met over a three-year period. Each performance award is equivalent to one share of Company A stock. The terms of the plan call for the awards to be settled two-thirds in stock and one-third in cash at the date the performance goals are attained (the settlement date). This plan may be viewed as a combination plan consisting of 600,000 shares of restricted stock and 300,000 cash SARs. The market price of Company A stock is $30 at grant date. The Company estimates that 750,000 performance awards will ultimately be earned based on the Company’s expectations of meeting benchmark goals and estimated forfeitures. Company A intends to settle the award by issuing 500,000 shares of stock and settling the remaining 250,000 units in cash based on the market price of Company A stock at the settlement date. The stock portion of the award is accounted for as a grant of an equity instrument. Company A would recognize compensation cost of $15 million (500,000 ϫ $30 per unit) over the three-year service period for the portion of the award expected to be settled in stock. The cash portion of the award would result in initial compensation cost of $7.5 million (250,000 ϫ $30) to be accrued as a liability over the participants’ service period. The amount of the liability will be adjusted each period based on fluctuations in the market price of the stock. If the market price of Company A stock is $36 at the end of the service period, additional compensation cost of $1.5 million would be recognized (250,000 ϫ $6). Exhibit 37.13 Combination plan under FASB Statement No. 123. [...]... However, there are special disclosure rules when hypothetical assumptions are improbable [see Subsection 38.4(c)(ii)] All the nonhypothetical assumptions in a projection are expected to occur if the hypothetical assumption occurred, which may be different from expecting the nonhypothetical assumption actually to occur For example, a company may hypothesize adding a new product line and intend to use... presentations of an entity’s financial position, results of operations, and cash flows for the future In addition to the AICPA Guide, there is also a Statement on Standards for Attestation Engagements No 10, Attestation Standards: Revision and Recodification: Chapter 3, “Financial Forecasts and Projections” (AT 301), which establishes standards for accountants’ services Entity means an individual, organization,... statements is generally management’s, based on its need and desires and those of potential financial statement users 38 10 • PROSPECTIVE FINANCIAL STATEMENTS Other bodies have also established rules concerning presentation and disclosure of forecasts and projections For example, the SEC, the North American Security Administrators Association, and individual state securities commissions have established... the assumptions represent management’s best estimate of future conditions and courses of action In a projection, the hypothetical assumptions are consistent with the purpose of the projection, and all the other assumptions represent management’s best estimate of future conditions and courses of action given the occurrence of the hypothetical assumptions Approaches to developing assumptions range from... differences between the 38.4 PRESENTATION AND DISCLOSURE OF PROSPECTIVE FINANCIAL STATEMENTS 38 13 • projected and actual results, because events and circumstances frequently do not occur as expected, and those differences may be material * If the presentation is summarized or condensed, this might read “ summary of the Company’s expected results of operations and changes in financial position ” If... formal presentation that includes the basis and rationale would be most useful for general users; the informal printout of factors from a spreadsheet might be appropriate, and least costly to prepare, for internal use The disclosure of significant assumptions should also indicate which assumptions are hypothetical and which are particularly sensitive The hypothetical assumptions used in a projection... used primarily by the client The AICPA performance and reporting standards recognize that the type of service that is appropriate in the circumstances may vary depending on the expected use The AICPA standards provide three standard accountants’ services for prospective financial statements expected to be used by third parties: compilation, examination, and application of agreed-upon procedures (No review... expectations, whereas projections are hypothetical analyses (i) Financial Forecasts Financial forecasts are defined as prospective financial statements that present, to the best of management’s knowledge and belief, an entity’s expected financial position, results of operations, and cash flows based on management’s assumptions reflecting conditions it expects to exist and the course of action it expects to... present, to the best of management’s knowledge and belief, an entity’s future financial position, results of operations, and cash flows given the occurrence of one or more hypothetical assumptions Financial projections are sometimes prepared to analyze alternative courses of action, as in response to a question such as “What would happen if ?” The hypothetical assumptions in a projection are those... explicit limit on the number of hypothetical assumptions used in a projection However, since a projection is a presentation of expectations based on the occurrence of the hypothetical assumptions, a presentation in which all significant assumptions have been hypothesized would not be a projection because it depicts no dependent expectations Thus, at some point the number of hypothetical assumptions may grow . 3 Option value at grant date $10) Estimated fair value of award at grant date: (10, 000 ϫ .94 ϫ .94 ϫ .94) ϫ $10 ϭ $83 ,100 ) Compensation cost recognized in years 1 and 2: $83 ,100 Ϭ 3 ϭ $27,700) Compensation. range: a. The number, weighted-average exercise price, and weighted-average remaining contrac- tual life of options outstanding, and b. The number and weighted-average exercise price of options currently. provide option holders with greater economic “up-side” potential and, accordingly, result in higher option values under the Black– Scholes and binomial option pricing models. FASB Statement No.