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In this chapter we look at some common forms of compensation in which the amount of the compensation employees receive is tied to the market price of company share. We will see that these share-based compensation plans – share awards, share options, and share appreciation rights – create shareholders’ equity. The nature of this compensation will impact the way we calculate earnings per share, the topic of the second part of this chapter.
Chapter 19 SHARE-BASED COMPENSATION AND EARNINGS PER SHARE © 2013 The McGraw-Hill Companies, Inc Share-Based Compensation Share Award Plans Compensation: • Salary • Share awards Restricted share plans • Usually tied to continuing employment, • Compensation is market price at date of grant, • Compensation expense accrued over service period 19 - Share Option Plans Share option plans give employees the option to buy (a) a specified number of shares of the firm's share, (b) at a specified exercise price, (c) during a specified period of time The fair value is accrued as compensation expense over the service period for which participants receive the options, usually from the date of grant to when the options become exercisable (the vesting date) 19 - Expense – The Great Debate Historically, options have been measured at their intrinsic value – the simple difference between the market price of the shares and the option price at which they can be acquired If the market and exercise price are equal on the date of grant, no compensation expense is recognized even if the options provide executives with substantial income 19 - Current Requirements Things Things changed changed in in November November 2002 2002 when when the the IASB IASB issued issued its its exposure exposure draft draft ED ED 22 on on Share-based Share-based Payment Payment (This (This was was followed followed by by the the standard standard IFRS IFRS No No 22 in in February February 2004.) 2004.) The The release release of of ED ED 22 came came in in the the aftermath aftermath of of the the accounting accounting scandals scandals and and the the “dot-com” “dot-com” crisis, crisis, and and the the shell-shocked shell-shocked market market were were more more willing willing to to accept accept aa higher higher level level of of discipline discipline with with regards regards to to disclosures disclosures on on management management compensation compensation Thus Thus the the requirement requirement for for companies companies to to measure measure options options at at their their fair fair values values at at the the time time they they are are granted granted and and to to expense expense that that amount amount over over the the appropriate appropriate service service period period became became required required under under both both IFRS IFRS and and U.S U.S GAAP GAAP 19 - Measurement Objectives 19 - Recognizing Fair Value of Options Accounting Accounting for for share share options options parallels parallels the the accounting accounting for for restricted restricted share share we we discussed discussed earlier earlier We We now now are are required required to to estimate estimate the the fair fair value value of of share share option option on on the the grant grant date date IFRS (and U.S GAAP) requires that compensation expense be measured using one of several option pricing models that deal with: Exercise price of the option Expected term of the option Current market price of the share Expected dividends Expected risk-free rate of return Expected volatility of the share 19 - Plans with Performance or Market Conditions If compensation from a share option depends on meeting a performance target, then whether we record compensation depends • Initially on the best available estimate of the expected number of options that will vest (i.e based on the company’s assessment of the likelihood of the performance target being met) and • Ultimately on whether the performance target actually is met If the target is based on changes in the market rather than on performance, we record compensation as if there were no target 19 - U S GAAP vs IFRS There are more similarities than differences in the treatment of share options One major difference is the treatment of deferred tax assets and when options have graded-vesting • 19 - A deferred tax asset (DTA) is created for the cumulative amount of the fair value of the options the company has recorded for compensation expense • Account for each vesting amount separately or account for the entire award on the straight-line basis over the entire vesting period • • The deferred tax asset is not created until the award is “in the money;” that is it has intrinsic value Straight-line choice is not permitted Companies not required to recognize the award that has vested by each reporting date Plans With Graded-Vesting Rather than share option plans vesting on a single date, more plans awards specify that recipients gradually become eligible to exercise their options rather than all at once This is called “graded vesting.” The company should view each vesting group separately, as if it were a separate award For example, a company may award share options that vest 25% in the first year, 25% in second year, and 50% the third years For accounting purposes we have three separate awards The straightline method is not allowed 19 - 10 Convertible Securities The if-converted method is used for convertible debt and equity securities The method assumes conversion occurs as of the beginning of the period or date of issuance, if later 19 - 32 Convertible Securities The assumed conversion of convertible bonds or preference shares has two effects on dilutive earnings per share: increases the denominator by the number of ordinary shares issuable upon conversion, increases the numerator by decreasing after-tax interest expense on convertible bonds, and dividends on convertible preference shares 19 - 33 Anti-Dilutive Securities For convertible securities (convertible bonds and convertible preference shares), we determine whether convertible securities are dilutive by comparing the “incremental effect” on EPS from the assumed conversion 19 - 34 Additional EPS Issues Contingently Issuable Shares Contingent Contingent shares shares are are issuable issuable in in the the future future for for little little or or no no cash cash consideration consideration upon upon the the satisfaction satisfaction of of certain certain conditions conditions Contingently Contingently issuable issuable shares shares are are considered considered to to be be outstanding outstanding in in the the computation computation of of EPS EPS ifif the the target target performance performance level level already already is is being being met met 19 - 35 Contingently Issuable Shares Contingent shares are included in dilutive EPS if: Shares Shares are are issued issued merely merely due due to to passage passage of of time time Some Some target target performance performance level level has has already already been been met met and and is is expected expected to to continue continue to to the the end end of of the the contingency contingency period period Example: Example: Additional Additional shares shares may may be be issued issued based based on on future future earnings earnings 19 - 36 Restricted Shares Restricted shares are quickly replacing share options as the share-based compensation plan of choice Like share options, the treasury stock method is used to calculate the number of shares in the denominator of the EPS equation Unlike share options, employees not pay to acquire their shares No adjustment to the numerator Denominator is increased using treasury method 19 - 37 Summary Potential Ordinary Shares Share options or warrants Restricted shares Convertible securities (bonds, notes, preference shares) Contingently issuable shares 19 - 38 Dilutive Effect Shown? Basic EPS Diluted EPS no yes no yes no no yes yes Summary Potential Ordinary Shares Share options or warrants Restricted shares Convertible bonds or notes Convertible preference shares Modification to Diluted EPS Equation Numerator Denominator Add incremental None shares None Add after tax interest Add back dividends declared Add shares created by vesting, reduced by repurchased shares at the average stock price Add shares issuable upon conversion Add shares issuable upon conversion Contingently issuable shares 19 - 39 Conditions being currently met None Conditions not being met None Add shares issuable None Financial Statement Presentation Report EPS data separately for: Income from Continuing Operations Discontinued Operations Net Income 19 - 40 Appendix 19A – Option-Pricing Theory Intrinsic Intrinsic value value is is the the benefit benefit the the holder holder of of an an option option would would realize realize by by exercising exercising the the option option rather rather than than buying buying the the underlying underlying share share directly directly An An option option that that permits permits an an employee employee to to buy buy $25 $25 share share for for $10, $10, has has an an intrinsic intrinsic value value of of $15 $15 Options Options have have aa time time value value because because the the holder holder of of an an option option does does not not have have to to pay pay the the exercise exercise price price until until the the option option is is exercised exercised 19 - 41 Summary The The fair fair value value of of an an option option is is (a) (a) its its intrinsic intrinsic value value plus plus (b) (b) its its time time value value of of money money plus plus (c) (c) its its volatility volatility component component All Other Factors Being Equal, If the: Exercise price is higher Term of the option is longer Market price of the stock is higher Dividends are higher Risk-free rate of return is higher Volatility of the stock is higher 19 - 42 The Option Value Will Be: Lower Higher Higher Lower Higher Higher Appendix 19B - Share Appreciation Rights The SARs are considered to be equity if the employer can elect to settle in shares; – Unless the employer has a present obligation to the employee to settle in cash, or unless the employee has a valid expectation to receive cash The amount of compensation is estimated at the grant date as the fair value of the SARs Usually the same as the fair value of a share option with similar terms This amount is expensed over the service period 19 - 43 Share Appreciation Rights The SARs are considered to be a liability if the employee has the right to receive cash upon settlement In that case, the amount of compensation (and related liability) is estimated each period and continuously adjusted to reflect changes in the fair value of the SARs until the compensation is finally paid The current expense (and adjustment to the liability) is the fraction of the total compensation earned to date by recipients of the SARs (based on the elapsed percentage of the service period), reduced by any amounts expensed in prior periods The employer may have to recognize the expense immediately if the services have already been received 19 - 44 Share Appreciation Rights 19 - 45 End of Chapter 19 ... aftermath aftermath of of the the accounting accounting scandals scandals and and the the “dot-com” “dot-com” crisis, crisis, and and the the shell-shocked shell-shocked market market were were... average outstanding outstanding ordinary ordinary share share Number of shares outstanding × Number of months outstanding ÷ 12 Weighted average shares outstanding *Current *Current period’s period’s... outstanding outstanding 19 - 21 Share Buy-Back Compute the weighted-average number of shares of ordinary share outstanding Date 1/1 4/1 5/1 19 - 22 Description Balance Issued Repurchased shares