Greg CallowMatt Faulkner Dana GiesMary Mumcuoglu Marcel NugentTracey Weiler - PowerPoint PPT Presentation

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Greg CallowMatt Faulkner Dana GiesMary Mumcuoglu Marcel NugentTracey Weiler

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Objectives Overview Controversy Accounting Treatment Lessons Learned. Greg Callow Matt Faulkner ... Greg Callow. Matt Faulkner. Dana Gies. Mary Mumcuoglu ... – PowerPoint PPT presentation

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Title: Greg CallowMatt Faulkner Dana GiesMary Mumcuoglu Marcel NugentTracey Weiler


1
Greg Callow Matt FaulknerDana Gies Mary
MumcuogluMarcel Nugent Tracey Weiler
Stock Options Management Compensation
  • Management Compensation
  • motivate employees to high levels of performance,
  • help retain executives and allow for recruitment
    of new talent,
  • base compensation on employee and company
    performance,
  • maximize employees after-tax benefit and
    minimize employees after tax cost, and
  • use performance criteria over which the employee
    has control.

Stock Options Defined securities issued by a
company that carry the right, but not the
obligation, to buy a certain amount of shares in
the company at a predetermined price
  • Lessons Learned
  • No longer reserved for executive suite
  • Still popular, even after the dot-com crash
  • Can be expensive to exercise
  • Two common types of plans
  • Nonqualified stock options
  • Qualified, or incentive stock options (ISOs)
  • Its usually smart to hold options as long as you
    can
  • There may be compelling reasons to exercise early
  • Stock options arent your only option for
    compensation

2
Stock Options Management Compensation
  • Greg Callow
  • Matt Faulkner
  • Dana Gies
  • Mary Mumcuoglu
  • Marcel Nugent
  • Tracey Weiler

3
Agenda
  • Learning Objectives
  • General Overview
  • Controversy
  • Accounting Treatment
  • Lessons Learned
  • Questions

4
Learning Objectives
  • Gain understanding of stock options and
    management compensation
  • Recognize the differences between past and
    current accounting treatment of stock options
  • Become familiar with stock option implications as
    they relate to employee and employer

5
Management Compensation
  • Purpose
  • motivate employees to high levels of performance,
  • help retain executives and allow for recruitment
    of new talent,
  • base compensation on employee and company
    performance,
  • maximize the employees after-tax benefit and
    minimize the employees after-tax cost, and
  • use performance criteria over which the employee
    has control.

6
How many of you have stock options in your
company?
How many of you would like to have stock options
in your company?
7
Types of Plans
  • Direct Awards of Stock
  • Compensatory Stock Option Plans (CSOPs)
  • Employee Stock Option Plans (ESOPs)
  • Stock Appreciation Rights Plan (SARs)
  • Performance-Type Plans
  • Incentive Stock Options ISO
  • Nonqualified Stock Options - NQS

8
Stock Options Defined
  • securities issued by a company that carry the
    right, but not the obligation, to buy a certain
    amount of shares in the company at a
    predetermined price
  • The strike price is typically set near the market
    price of the stock on the day the option is
    granted
  • Employees must typically wait a specified vesting
    period before being allowed to exercise the
    option

9
Stock Option Motivations
  • The idea behind stock options
  • To motivate employeesincrease performance
  • To offer uncapped potential gain through
    increased stock price
  • To allow companies to retain talent in the early
    years
  • To foster a culture of employee ownership
  • To align incentives between the employees and
    shareholders of a company

10
Shareholders vs. Managers
  • Long term growth
  • Investment growth
  • Seek what is in the best
  • interests of the company
  • Bonus based on short
  • term results such as
  • earnings growth
  • Seek what is in the best
  • interests of themselves

Stock options attempt to better align interests
of employees with shareholders by maintaining a
long term growth potential
11
In Practice
  • Closely-held companies often issue stock options
  • IPO driven
  • Public companies
  • Some industries, it has become standard practice
    such as in high-tech

From 1997 to 2002, use of stock options in Canada
more than doubled from 25 to 59
12
Can anyone think of the main reasons for what was
good in theory, but ended up being bad in
practice?
13
The Good vs. The Bad
  • Focus remained on quarterly performance rather
    than on long term
  • Were allowed to sell stock after exercising
    options
  • What do you think about amending option plans to
    require employees to hold their shares for a year
    or two after exercising them?
  • Tax laws allowed managements to manage earnings
    by increasing the use of options instead of cash
    wages
  • If a company wished to maintain its EPS growth
    rate and they thought it might be difficult to do
    so, they could implement new option programs thus
    reducing growth in cash wages.

14
The Ugly
  • Option abuse has 3 major adverse impacts
  • Oversized rewards given by servile boards to
    ineffective executives
  • In earlier years, BODs allowed executives to
    exercise and sell stock with less restrictions
    than those placed on lower-level employees
  • Repricing options rewards underperformers at the
    expense of the common shareholder
  • Repricing out of the money options in order to
    keep employees from leaving
  • Who will reprice the shareholders shares?

15
The Ugly cont
  • 3. Increases dilution risk as more and more
    options are issued
  • EPS dilution from an increase in shares
    outstanding
  • Earnings reduced by increased interest expense
  • Management dilution management spending more
    time maximizing option payout and financing stock
    repurchase programs than running the business

16
The Ugly cont
Options only align the interest of employees with
shareholders if they are structured so that
flipping is eliminated and the same vesting and
selling rules apply to every employee, whether
C-level or janitor
17
Accounting Treatment
  • To Expense or Disclose?
  • Should employers expense stock option costs in
    calculating net income?
  • Employers already disclose the cost in the notes
    to the financial statements and must show the
    potential impact on earnings.
  • Expensing options significantly reduces EPS
  • Companies can deduct for tax purposes
  • GAAP doesnt require expense of options

Study by Bear Stearns in 02 estimates that, had
the fair value of stock options been expensed in
2001, aggregate diluted EPS for the SP 500 would
have been reduced 20 Similarly, according to
Standard Poors, expensing options would reduce
reported 2004 earnings among the SP 500 by 7.4
while the effect on many technology firms would
be much greater. For example, in an August 2,
2004, press release, Intel reported that its
second-quarter 2004 profit would have decreased
17 if it had expensed its stock options
18
Accounting Treatment cont
Expensing voluntary Disclosure - mandatory
Expensing mandatory for public co.s
Expensing mandatory for US co.s
Expensing mandatory for private co.s
Fair value or disclose
Jan 1 2002
Jan 1 2004
Pre 2002
Jan 1 2005
Aug 1 2005
S. 3870 a) scholes b) binomial
US FSAB regulates
No standard under GAAP
ASB followed the US approach using the
fair-value-based accounting method. In 2002,
CICA Handbook Section 3870 set standards for the
recognition, measurement and disclosure of
stock-based compensation
19
Canada
  • Pre 2002 no standard under GAAP
  • Jan. 1 2002 - CICA introduced section 3870
    (Canadian Standard) Fair value of the stock
    options is determined and recorded as
    compensation expense over the vesting period of
    the option - starting 2002
  • Jan. 1 2004 mandatory expense for public
    companies
  • Jan. 1 2005 mandatory expense for private
    companies

20
Impact to Cott Corp. Nortel
  • Cotts NI before option compensation was 6.14 M
    in 02
  • Including the impact of options decreased NI to a
    loss of 2.36 M, a decrease of 140
  • Nortel reported a net loss of 5.631 B in 02
  • Including the impact of options increased this
    loss to 7.13 billion, an impact of nearly 27 or
    1.5 B

21
SFAS. No. 123 (US Standard)
  • Pre 1995 choice was up to the company
  • Then in 1995, the initial proposal surfaced that
    would require companies to expense the total fair
    value of options.
  • There was strong opposition.
  • Status quo continued and they had a choice
  • recognizing on the Income Statement or,
  • disclosing in a footnote
  • Amortize total fair value over vesting period of
    the stock options (SFAS 123 Revised 2004)
  • August 1st 2005, required to recognize as an
    expense on the Income Statement

22
IFRS 2 (International Standard)
  • Requires all entities to recognize share based
    compensation as an expense
  • Fair value method is applied
  • Improves comparability of financial reporting
    around the world

23
Disclosure
  • Current Regulations include
  • Separate description of multiple plans
  • where companies have gt one stock-based
    compensation plan
  • Which options-pricing model is used
  • Including underlying assumptions
  • Number and weighted average exercise price of
    options
  • Outstanding at beginning and end of the year
  • Granted during the year
  • Exercised, forfeited or expired during the year
  • Exercisable at the end of the year

24
What potential solutions would you propose?
  • Expensing is only one part, we also need
  • ethical management
  • governance
  • controls
  • disclosure
  • Expensing Options Solves Nothing, William
    Sahlman. Harvard Business Review, Dec. 02

25
Accounting Treatment cont
  • Real Debate centered around value
  • Fair value option pricing models require many
    assumptions, all of which vary over time
  • Black-Scholes Model
  • Timing when the actual expense is incurred
  • When awarded?
  • When exercised?

The requirement of stock option expensing is the
most controversial standard ever proposed in
Canada and in the US (FASB).
26
Valuation
  • Pre S.3870
  • Intrinsic approach
  • Record expense as the amount that the market
    price exceeded the exercise price at its grant
    date
  • Where market was not gt exercise price, companies
    were not required to record impact
  • Post S. 3870
  • Fair value, using any method
  • Black-Scholes
  • Binomial

27
Taxation
Taxation
  • Benefits from stock options are included in
    employment income in year in which they are
    disposed
  • ? favourable to employees
  • Also popular with employers because there is no
    immediate cash cost
  • ? favourable to employers

28
Future direction
  • Eliminate options altogether
  • Direct award of stock would eliminate the value
    debate
  • Direct award of cash
  • To reduce the dilutive effect, implement stock
    repurchase programs

29
Weaknesses
  • Still not focus employees on long-term financial
    goals
  • Little corporate governance
  • Outside the scope of management controls 
  • Not immediate benefits

30
Strengths
  • Motivates and retains employees
  • Cash is infused into companies when employees
    exercise their options
  • Great upside (gain) benefit potential

31
Its time to play Family Feud
32
Lessons Learned
  • No longer reserved for executive suite
  • Still popular, even after the dot-com crash
  • Can be expensive to exercise
  • Two common types of plans
  • Nonqualified stock options
  • Qualified, or incentive stock options (ISOs)
  • Its usually smart to hold options as long as you
    can
  • There may be compelling reasons to exercise early
  • Stock options arent your only option for
    compensation

33
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