Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Greg CallowMatt

Objectives Overview Controversy Accounting Treatment Lessons LearnedObjectives Overview Controversy Accounting Treatment Lessons Learned

Greg CallowGreg Callow Matt FaulknerMatt FaulknerDana GiesDana Gies Mary MumcuogluMary MumcuogluMarcel NugentMarcel Nugent Tracey WeilerTracey Weiler

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 employee’s after-tax benefit and minimize employee’s 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 LearnedNo 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)

It’s usually smart to hold options as long as you can

There may be compelling reasons to exercise early

Stock options aren’t your only option for compensation

Stock Options & Management CompensationStock Options & Management Compensation

Stock Options & Stock Options & Management CompensationManagement Compensation

Greg CallowGreg CallowMatt FaulknerMatt Faulkner

Dana GiesDana GiesMary MumcuogluMary Mumcuoglu

Marcel NugentMarcel NugentTracey WeilerTracey Weiler


AgendaAgenda

Learning ObjectivesLearning Objectives General OverviewGeneral Overview ControversyControversy Accounting TreatmentAccounting Treatment Lessons LearnedLessons Learned QuestionsQuestions


Learning ObjectivesLearning Objectives

Gain understanding of stock options Gain understanding of stock options and management compensationand management compensation

Recognize the differences between Recognize the differences between past and current accounting past and current accounting treatment of stock optionstreatment of stock options

Become familiar with stock option Become familiar with stock option implications as they relate to implications as they relate to employee and employeremployee and employer


Management CompensationManagement Compensation

Purpose:Purpose:– motivate employees to high levels of motivate employees to high levels of

performance,performance,– help retain executives and allow for help retain executives and allow for

recruitment of new talent,recruitment of new talent,– base compensation on employee and base compensation on employee and

company performance,company performance,– maximize the employee’s after-tax benefit and maximize the employee’s after-tax benefit and

minimize the employee’s after-tax cost, anminimize the employee’s after-tax cost, andd– use performance criteria over which the use performance criteria over which the

employee has control.employee has control.


How many of you have stock How many of you have stock options in your company?options in your company?

How many of you would like to How many of you would like to have stock options in your have stock options in your company?company?


Types of PlansTypes of Plans

Direct Awards of StockDirect Awards of Stock Compensatory Stock Option Plans Compensatory Stock Option Plans

(CSOPs)(CSOPs) Employee Stock Option Plans (ESOPs)Employee Stock Option Plans (ESOPs) Stock Appreciation Rights Plan (SARs)Stock Appreciation Rights Plan (SARs) Performance-Type PlansPerformance-Type Plans Incentive Stock Options – ISOIncentive Stock Options – ISO Nonqualified Stock Options - NQSNonqualified Stock Options - NQS


Stock Options DefinedStock Options Defined

……securities issued by a companysecurities issued by a company that carry the right, but that carry the right, but not the obligation, to buy a certain amount of shares in not the obligation, to buy a certain amount of shares in

the company at a predetermined price…the company at a predetermined price…

The strike price is typically set near the market price of the The strike price is typically set near the market price of the stock on the day the option is grantedstock on the day the option is granted

Employees must typically wait a specified vesting period Employees must typically wait a specified vesting period before being allowed to exercise the option before being allowed to exercise the option


Stock Option MotivationsStock Option Motivations

The idea behind stock options:The idea behind stock options: To motivate employees…increase performanceTo motivate employees…increase performance To offer uncapped potential gain through increased stock priceTo offer uncapped potential gain through increased stock price To allow companies to retain talent in the early yearsTo allow companies to retain talent in the early years To foster a culture of employee ownershipTo foster a culture of employee ownership To align incentives between the employees and shareholders To align incentives between the employees and shareholders

of a companyof a company


Shareholders vs. ManagersShareholders vs. ManagersLong term growth Long term growth

Investment growthInvestment growth

Seek what is in the bestSeek what is in the best

interests of the companyinterests of the company

Bonus based on short Bonus based on short

term results such asterm results such as

earnings growthearnings growth

Seek what is in the best Seek what is in the best

interests of themselvesinterests of themselves

Stock options attempt to better align interests of employees with shareholders by

maintaining a long term growth potential


In PracticeIn Practice

Closely-held companies often issue stock optionsClosely-held companies often issue stock options IPO drivenIPO driven

Public companiesPublic companies Some industries, it has become standard Some industries, it has become standard

practice such as in high-techpractice such as in high-tech

From 1997 to 2002, use of stock options in Canada more than doubled from 25% to 59%


Can anyone think of the main Can anyone think of the main reasons for what was good in reasons for what was good in

theory, but ended up being bad in theory, but ended up being bad in practice?practice?


The Good vs. The BadThe Good vs. The Bad

1.1. Focus remained on quarterly performance rather Focus remained on quarterly performance rather than on long termthan on long term

Were allowed to sell stock after exercising optionsWere allowed to sell stock after exercising options What do you think about amending option plans to What do you think about amending option plans to

require employees to hold their shares for a year or two require employees to hold their shares for a year or two after exercising them?after exercising them?

2.2. Tax laws allowed managements to manage Tax laws allowed managements to manage earnings by increasing the use of options instead earnings by increasing the use of options instead of cash wagesof cash wages

If a company wished to maintain its EPS growth rate If a company wished to maintain its EPS growth rate and they thought it might be difficult to do so, they and they thought it might be difficult to do so, they could implement new option programs thus reducing could implement new option programs thus reducing growth in cash wages. growth in cash wages.


The UglyThe Ugly Option abuse has 3 major adverse Option abuse has 3 major adverse

impacts:impacts:1.1. Oversized rewards given by servile Oversized rewards given by servile

boards to ineffective executivesboards to ineffective executives1.1. In earlier years, BODs allowed executives to In earlier years, BODs allowed executives to

exercise and sell stock with less restrictions exercise and sell stock with less restrictions than those placed on lower-level employeesthan those placed on lower-level employees

2.2. Repricing options rewards Repricing options rewards underperformers at the expense of the underperformers at the expense of the common shareholdercommon shareholder

1.1. Repricing “out of the money” options in order Repricing “out of the money” options in order to keep employees from leavingto keep employees from leaving

2.2. Who will reprice the shareholders’ shares?Who will reprice the shareholders’ shares?


The Ugly cont…The Ugly cont…

3. Increases dilution risk as more 3. Increases dilution risk as more and more options are issuedand more options are issued

1.1. EPS dilution from an increase in EPS dilution from an increase in shares outstandingshares outstanding

2.2. Earnings reduced by increased interest Earnings reduced by increased interest expenseexpense

3.3. Management dilution – management Management dilution – management spending more time maximizing option spending more time maximizing option payout and financing stock repurchase payout and financing stock repurchase programs than running the businessprograms than running the business


The Ugly cont…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


Accounting TreatmentAccounting 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 doesn’t 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 S&P 500 would have been reduced 20%

Similarly, according to Standard & Poor’s, expensing options would reduce reported 2004 earnings among the S&P 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


Accounting Treatment cont…Accounting Treatment cont…

Jan 1 2002 Jan 1 2004

Expensing – voluntaryDisclosure - mandatory

Fair value or disclose

Expensing – mandatory for

public co.’s

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

Pre 2002 Jan 1 2005

No standard under GAAP

S. 3870 a) scholesb) binomial

Expensing – mandatory for private co.’s

Aug 1 2005

Expensing – mandatory for

US co.’s

US FSAB regulates


CanadaCanada

Pre 2002 – no standard under GAAPPre 2002 – no standard under GAAP Jan. 1 2002 - CICA introduced Jan. 1 2002 - CICA introduced

section 3870 (Canadian Standard): section 3870 (Canadian Standard): Fair value of the stock options is Fair value of the stock options is determined and recorded as determined and recorded as compensation expense over the compensation expense over the vesting period of the option - starting vesting period of the option - starting 20022002

Jan. 1 2004 – mandatory expense Jan. 1 2004 – mandatory expense for public companiesfor public companies

Jan. 1 2005 – mandatory expense Jan. 1 2005 – mandatory expense for private companiesfor private companies


Impact to Cott Corp. & NortelImpact to Cott Corp. & Nortel

Cott’s NI before option Cott’s NI before option compensation was compensation was $6.14 M in ’02$6.14 M in ’02

Including the impact of Including the impact of options decreased NI options decreased NI to a loss of $2.36 M, a to a loss of $2.36 M, a decrease of ~140%decrease of ~140%

Nortel reported a net Nortel reported a net loss of $5.631 B in ’02loss of $5.631 B in ’02

Including the impact of Including the impact of options increased this options increased this loss to $7.13 billion, an loss to $7.13 billion, an impact of nearly 27% impact of nearly 27% or ~$1.5 Bor ~$1.5 B


SFAS. No. 123 (US Standard)SFAS. No. 123 (US Standard)

Pre 1995 – choice was up to the company Pre 1995 – choice was up to the company Then in 1995, the initial proposal surfaced that Then in 1995, the initial proposal surfaced that

would require companies to expense the would require companies to expense the totaltotal fair fair value of options.value of options.

There was strong opposition. There was strong opposition.

1.1. Status quo continued and they had a choice: Status quo continued and they had a choice: 1.1. recognizing on the Income Statement or,recognizing on the Income Statement or,

2.2. disclosing in a footnotedisclosing in a footnote

2.2. Amortize total fair value over vesting period of the Amortize total fair value over vesting period of the stock options (SFAS 123 – Revised 2004)stock options (SFAS 123 – Revised 2004)

3.3. August 1August 1stst 2005, required to recognize as an 2005, required to recognize as an expense on the Income Statementexpense on the Income Statement


IFRS 2 (International IFRS 2 (International Standard)Standard)

Requires all entities to recognize Requires all entities to recognize share based compensation as share based compensation as an expensean expense

Fair value method is appliedFair value method is applied Improves comparability of Improves comparability of

financial reporting around the financial reporting around the worldworld


DisclosureDisclosure

Current Regulations include: Current Regulations include:

1.1. Separate description of multiple plansSeparate description of multiple plans• where companies have > one stock-based where companies have > one stock-based

compensation plancompensation plan

2.2. Which options-pricing model is usedWhich options-pricing model is used• Including underlying assumptionsIncluding underlying assumptions

3.3. Number and weighted average exercise price of Number and weighted average exercise price of options:options:

• Outstanding at beginning and end of the yearOutstanding at beginning and end of the year• Granted during the yearGranted during the year• Exercised, forfeited or expired during the yearExercised, forfeited or expired during the year• Exercisable at the end of the yearExercisable at the end of the year


What potential solutions would What potential solutions would you propose?you propose?

Expensing is only one Expensing is only one part, we also need:part, we also need: ethical managementethical management governancegovernance controlscontrols disclosuredisclosure

““Expensing Options Solves Expensing Options Solves Nothing”, Nothing”, William William Sahlman. Sahlman. Harvard Harvard Business Review, Dec. ‘02Business Review, Dec. ‘02


Accounting Treatment cont…Accounting Treatment cont…

Real Debate centered around valueReal Debate centered around value Fair value – option pricing models Fair value – option pricing models

require many assumptions, all of which require many assumptions, all of which

vary over timevary over time Black-Scholes ModelBlack-Scholes Model

Timing – when the actual expense is Timing – when the actual expense is incurredincurred

When awarded?When awarded? When exercised?When exercised?

The requirement of stock option expensing is the most controversial standard ever proposed in Canada and in the US (FASB).


ValuationValuation

Pre S.3870Pre S.3870 Intrinsic approach Intrinsic approach

Record expense as the amount that the Record expense as the amount that the market price exceeded the exercise price at market price exceeded the exercise price at its grant dateits grant date

Where market was not > exercise price, Where market was not > exercise price, companies were not required to record companies were not required to record impactimpact

Post S. 3870Post S. 3870 Fair value, using any methodFair value, using any method

Black-ScholesBlack-Scholes BinomialBinomial


TaxationTaxation

Benefits from Benefits from stock options stock options are included in are included in employment employment income in year income in year in which they in which they are disposed are disposed

favourable to favourable to employeesemployees

Also popular Also popular with employers with employers because there because there is no immediate is no immediate cash cost cash cost

favourable to favourable to employersemployers

TaxationTaxation


Future directionFuture direction

Eliminate options altogetherEliminate options altogether Direct award of stock would Direct award of stock would

eliminate the value debateeliminate the value debate Direct award of cashDirect award of cash

To reduce the dilutive effect, To reduce the dilutive effect, implement stock repurchase implement stock repurchase programsprograms


WeaknessesWeaknesses

Still Still not focus employees on long-term financial goals

Little corporate governance

Outside the scope of management controls

Not immediate benefits


StrengthsStrengthsMotivates and retains

employees Cash is infused into Cash is infused into

ccompanies when employees exercise their options

Great upside (gain) benefit potential


It’s time to play Family Feud…It’s time to play Family Feud…


Lessons LearnedLessons Learned

No longer reserved for executive No longer reserved for executive suitesuite

Still popular, even after the dot-com Still popular, even after the dot-com crashcrash

Can be expensive to exerciseCan be expensive to exercise Two common types of plansTwo common types of plans

Nonqualified stock options Nonqualified stock options Qualified, or “incentive” stock options Qualified, or “incentive” stock options

(ISOs)(ISOs) It’s usually smart to hold options as It’s usually smart to hold options as

long as you canlong as you can There may be compelling reasons to There may be compelling reasons to

exercise earlyexercise early Stock options aren’t your only option Stock options aren’t your only option

for compensationfor compensation


Questions?Questions?

Documents

Objectives Overview Controversy Accounting Treatment Lessons Learned Objectives Overview Controversy Accounting Treatment Lessons Learned Greg CallowMatt