Audit Tax Advisory 0 Cal State Fullerton

Audit Tax AdvisoryAudit Tax Advisory

1

Cal State Fullerton

CCRG’s “SEC Financial Reporting Conference”

Cal State Fullerton

CCRG’s “SEC Financial Reporting Conference”

Seth Rosen(213) 955-8814

KPMG LLPSeptember 19, 2005

Seth Rosen(213) 955-8814

KPMG LLPSeptember 19, 2005

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© 2 0 0 4 K PM G L L P , t h e U . S . m e m b e r f i r m o f K PM G I n t e r n a t i o n a l , a S wi s s c o o p e r a t i v e . A l l r i g h t s r e s e r v e d .

Audit Tax AdvisoryAudit Tax Advisory

Expensing Stock Options Under New FAS 123 Expensing Stock Options Under New FAS 123

Audit Tax AdvisoryAudit Tax Advisory2

Accounting HistoryAccounting History

Intrinsic Value versus Fair Value Method

Companies have been able to select one of two approaches

APB Opinion 25 (“APB 25”) – compensation cost equals the market value of the stock at the measurement date minus the exercise price

This “intrinsic value” method results in zero cost for most “fixed plan” stock option grants



Intrinsic versus Fair Value Method, continued

Original FASB Statement 123 (“FAS 123”) - recommends the use of the “fair value” method of accounting

Stock options are valued at the date of grant using an option-pricing model such as Black-Scholes

If companies choose the “intrinsic value” method (APB 25) over the “fair value” method (FAS 123), they must still disclose the “fair value” in the footnotes to the financial statement



Intrinsic versus Fair Value AccountingMost companies have chosen intrinsic value under APB 25, with footnote disclosure of fair value pursuant to FAS 123.

Fixed Accounting (Under APB 25)If both the number of shares granted to an employee and the exercise price of the shares are known at the time of grant, the grant date is the measurement date, and compensation cost, if any, is fixed as of that date.

Variable Accounting (Under APB 25)Measurement date not known, compensation cost is remeasured by mark-to-intrinsic value until award becomes fixed.

Note: No variable accounting for equity awards under the FAS 123.


FAS 123R Changes the Ground RulesFAS 123R Changes the Ground Rules

Effective Date

Public companies – fiscal years beginning after June 15, 2005

Non-public companies -- fiscal years beginning after December 15, 2005


FAS 123R Changes the Ground Rules FAS 123R Changes the Ground Rules

Transition – Equity Awards

Recognize compensation cost based on grant date fair value for all granted, modified or settled after effective date

Recognize compensation cost for unvested portion of awards outstanding at the effective date using fair value previously reported in the notes or in income statement

May want to consider vesting underwater options pre-effective date



Cost measured at grant based on the fair value of the instruments granted;

No valuation model is preferred

Binomial model is similar to Black-Scholes re inputs

However, lattice approach creates flexibility and complexity



Performance Condition

Condition affecting vesting of an award that depends on (a) employee rendering service for a specified period or implied period and (b) achieving specified performance targets defined by reference to employer’s operations (e.g. sales growth, EPS, market share)

Market condition

Condition affecting exercisability or exercise price of an award that depends on the achievement of a (a) market price of the company’s stock or specified amount of intrinsic value or (b) specified market performance on the company’s stock (e.g., change in market price compared to change in S&P 500 index)


Valuation Models Valuation Models

Black-Scholes Option Pricing Model Inputs

Exercise Price

Current Stock Price

Expected Life of the Option

Expected Volatility

Expected Dividend Yield

Risk-free Interest Rate during Expected Life


Valuation Models – Binomial LatticeValuation Models – Binomial Lattice

Same six factors as for the Black Scholes Merton Formula

Plus:

Multiple number of steps

Vesting period

Sub-optimal early exercise behavior parameters:

Post-vesting forfeiture rate (e.g. vest & move)

Early exercise multiple to model non-transferability


Tax Implications Tax Implications

Share based awards result in a temporary difference

Deferred tax benefit recorded as compensation expense is recognized

Assume deduction equal to expense

Actual tax benefit in excess of amount recognized is recorded as APIC

Actual tax benefit below amount recognized results in reduction of tax benefit recognized and additional expense unless

Accumulated APIC from excess tax benefits from previous share based awards under hypothetical FAS 123 since 1995


Current and Future Plan TrendsCurrent and Future Plan Trends

Under FASB 123R…

Performance-based equity plans will be more widely used

Most common types of performance-based equity approaches will be:

Vesting contingent on a company specific Internal Financial Performance Measure(s)

Vesting contingent on Internal Financial Performance Measure(s) results versus an industry benchmark or peer group average

Vesting contingent on quantifiable individual executive goals



Other Changes…

Companies will consider valuation models and expense considerations prior to making awards

Non-qualified stock options

May be a reduction in size of award and population eligible

Stock appreciation rights (settled in shares)

Restricted stock units

Subject to consistency with deferred compensation rules enacted in 2004



Under FASB’s 123R…Several stock option plans are relatively less attractive compared to Non-qualified stock options:

Incentive stock options (ISOs)

• Lack of deductibility will increase net compensation expense (cannot assume a disqualifying disposition will occur)

ESPP plans are less attractive and there is a decline in the number of ESPP plans being utilized

Trend in 2005 has been some changes and lots of waiting to see what peer companies are doing

Technology companies tend to be sticking with options


Questions / ContactsQuestions / Contacts

Seth M. Rosen(213) [email protected]

Documents

Audit Tax Advisory 0 Cal State Fullerton