Watsonwyatt.com 2007 ALI-ABA Executive Compensation Course of Study: Strategy, Design, and Implementation What Does Accounting Bring to the Table? Nick

watsonwyatt.com

2007 ALI-ABA Executive Compensation Course of Study: Strategy, Design, and Implementation

What Does Accounting Bring to the Table?

Nick Bubnovich and Steve Seelig

June 21, 2007

Copyright © Watson Wyatt Worldwide. All rights reserved

2

Introduction / Agenda

This presentation provides an overview of how FAS 123R affects the proxy disclosure of different elements of compensation

Topics are presented in the following main categories:

The September 8, 2006 rules

The December 29, 2006 amendment

What is total compensation?

A Taste of FAS 123R

How’d That Happen?


3

Overview

Summary Compensation Table

Outstanding Equity Awards at Year-End

Equity RealizedDuring the Year

Grants of Plan-Based Awards

DC NonqualifiedDB Retirement

Compensation Discussion and Analysis

Termination Payments

The Final Regulations issued September 8, 2006 required equity grant disclosure in several tables


4

December 29, 2006 – Major Changes Summary Compensation Table equity grants disclosed at their grant

date fair value under FAS 123R, as disclosed on the financial statement

SEC Disclosure September 26, 2006 December 29, 2006 amendment

Vesting Schedule Disregarded Expense to be amortized over the service period

Performance Conditions

Disregarded at grant date unless “probable”

Expense recognized when “probable”

Market Conditions Included in Fair Value Included in Fair Value

Estimates of Forfeitures

Taken into account in initial disclosure

Disregard estimates of forfeitures in fair value calculations – prior expense recaptured in year of forfeiture

Prior year grants Not recognized Those expensed during the current year are disclosed

Variable Expenses Not recognized in subsequent periods

Disclosed in the year expense is recognized

Dividends and DEUs Not recognized Not recognized


5

December 29, 2006 – Major Changes

Name and Principal Position

(a)

Stock Awards ($)(e)

Option Awards ($)(f)

Total ($)(j)

September 26, 2006

2006 Grant $837 $279 $1,116

December 29, 2006 amendment

2003 Grant $1,000/4 = $250 $333/4 = $83 $333

2004 Grant $1,000/4 = $250 $333/4 = $83 $333

2005 Grant $1,000/4 = $250 $333/4 = $83 $333

2006 Grant $1,000/4 = $250 $333/4 = $83 $333

PEO Total $1,000 $333 $1,333

continued

Example: 100 SARs and 100 RSUs granted on 1/1/03, 1/1/04, 1/1/05 and 1/1/06 assuming a constant $10 per share stock value each year with a 4 year vesting schedule. Black Sholes value = 33%; 7% annual forfeiture rate


6

December 29, 2006 – Major Changes Some companies have included a supplemental table using the old

rules

– (1)Fair value, as determined under FAS 123R, of target performance shares, for the performance period January 1, 2007 through December 31, 2009, and restricted stock unit awards. These have been valued based on the grant date fair value estimated by the Company for financial reporting purposes on February 22, 2007 ($28.80 per share for the performance shares and $25.87 per share for the restricted stock units) and may not reflect the value of the award upon payment.

continued


7

What is Total Compensation?

AP: CEO received $15.2 million in compensation last year: salary, bonus, incentives, perks, above-market returns on deferred compensation and the full FAS 123R value.

WSJ: CEO earned $8.3 million in salary and bonus. CNN/Money: CEO received $17.9 million in compensation last year. Reuters/Corporate Library: CEO pay at $13.1 million. The story indicates they assigned a

higher value to his option component and lower to his stock awards.

continued


8

A Taste of FAS 123R Cost to be recognized over requisite service period

– Period during which an employee is required to provide service in exchange for an award - often the vesting period

– Service period may have to be derived for awards with certain types of performance conditions that are not time-specific

Example: RSUs vest when share closing price is $30

– If there is no requisite service period, full expense is recorded up-front

Example: RSUs that fully vest at normal retirement age regardless of the vesting schedule for an employee who already has attained that age


Vesting Schedule Disregarded Expense to be amortized over the service period


9

A Taste of FAS 123R Recognition Where Only Service Conditions Exist

– FAS 123R allows alternative approaches for stock awards with graded vesting

Can use front-loaded (FIN 28) or straight-line approach– FIN 28 treats each vesting tranche as a separate grant (with a

separate straight-line requisite service period for each tranche)– The following comparison illustrates the portion of cost recognized

each year (based on four-year graded vesting):

* 25% of grants - 1 year vest (25%); 25% of grants – 2 year vest (12.5%); 25% of grants – 3 year vest (8.33%); 25% of grants – 4 year vest (6.25%)

Attribution Method

Approximate Percent of Cost Recognized Each Year

1 2 3 4

Straight Line 25% 25% 25% 25%

FIN 28 52% * 27% 15% 6%

continued


10

A Taste of FAS 123R


(a)

Stock Awards ($)(e)

Option Awards ($)(f)

Total ($)(j)

Straight Line

2003 Grant $1,000 * 25% = $250 $333 * 25% = $83 $333

2004 Grant $1,000 * 25% = $250 $333 * 25% = $83 $333

2005 Grant $1,000 * 25% = $250 $333 * 25% = $83 $333

2006 Grant $1,000 * 25% = $250 $333 * 25% = $83 $333

PEO Total $1,000 $333 $1,333

FIN 28

2003 Grant $1,000 * 6% = $ 60 $333 * 6% = $ 20 $ 84

2004 Grant $1,000 * 15% = $150 $333 * 15% = $ 50 $210

2005 Grant $1,000 * 27% = $270 $333 * 27% = $ 90 $378

2006 Grant $1,000 * 52% = $520 $333 * 52% = $173 $728

PEO Total $1,000 $333 $1,333

continued

Example: 100 SARs and 100 RSUs granted on 1/1/03, 1/1/04, 1/1/05 and 1/1/06 assuming a constant $10 per share stock value each year with a 4 year vesting schedule. Black Sholes value = 33%


11

A Taste of FAS 123R Performance and Market Conditions

– Performance Conditions (net income or revenue target) Vesting measures based on performance metrics that are not stock

price related Not factored into the award's grant-date fair value However, the “probable” outcome of that performance condition (i.e.,

will vesting occur) does influence the compensation cost If condition is not met, ultimately no recorded compensation expense

– Any previously recorded charge for unvested options are reversed

– Market Condition Stock price, a market index, or intrinsic value such as Total

Shareholder Return (TSR) A factor in determining the award's grant-date fair value. Company must record a compensation expense regardless of whether

the condition is met or option becomes exercisable.


Performance Conditions Disregarded at grant date unless “probable”

Expense recognized when “probable”

Market Conditions Included in Fair Value Included in Fair Value

continued


12

A Taste of FAS 123R Performance and Market Conditions

Example

Restricted stock grant at $10 stock price with 1 year vesting

Service Market Performance

Condition Continued service only

TSR exceeds peer group

Revenues increase 10%

Grant Date FV $10 $7 $10

Expense - Condition Met

$10 $7 $10

Expense - Condition Not Met

$0 $7 $0

Expense – Quit before 1 year

$0 $0 $0

continued


13

A Taste of FAS 123R Forfeiture Assumptions

– FAS 123R expense is recognized based on shares granted minus assumed forfeitures (non-vested cancellations)

– Over the vesting period, the expense is reconciled to the number of actual forfeitures experienced – Can create negative numbers

– Two approaches to true-ups: Monitor: Companies may monitor experience versus

assumed and establish a variance threshold to determine when to true-up

True Up: Companies may true-up each period to reflect the current period’s experience versus assumed


Estimates of Forfeitures Taken into account in initial disclosure

Disregard estimates of forfeitures in fair value calculations – prior expense recaptured in year of forfeiture

continued


14

A Taste of FAS 123R Forfeiture Assumptions

Example

100 options granted with a $10 fair value and 2-year cliff vesting 10% initial assumed forfeitures Actual forfeitures of 2% in Year 1 and 5% in Year 2

Monitor True Up Each Period

Year 1 Expense $450 (= 100 * 90% * $10 divided by 2)

$465 (= 100 * 93% * $10 divided by 2)

Year 2 Expense $480 (= 100 * 93% * $10 minus $450)

$465 (= 100 * 93% * $10 minus $465)

Total Expense $930 $930

continued


15

A Taste of FAS 123R Equity v. Liability Awards

– Equity awards are those that are settled in shares Equity awards are generally measured at fair value at

grant (fixed)– Liability awards are generally those that are settled in cash

or remove the risk of stock ownership from participants (i.e., those with certain repurchase features)

– Liability awards are re-measured at fair value at each reporting date until they are settled (variable)


Variable Expenses Not recognized in subsequent periods

Disclosed in the year expense is recognized

continued


16


Equity Instruments Liability Instruments

Characteristic Expected to be settled in shares Expected to be settled in cash

Cost Based OnFair value of Award at Grant Date (fixed)

Fair value of award marked-to-market while outstanding (variable)

Cost Recognized

Over service period Through settlement

Examples:

Stock OptionsStock settled SARsRestricted StockStock settled RSUsPerformance SharesESPPs

Cash settled SARsCash settled RSUsPerformance CashOther awards (where fair value not measured at grant)

continued


17


Example

100 SARs granted on 1/1/2006 at $10 with one year vesting December 31, 2006 stock price is $15 SARs are exercised on July 1, 2007 at $20

Stock Settled Cash Settled

1/1/06 fair value $5.00 $5.00

12/31/06 fair value N/A $7.50

2006 expense $500 $750

2007 expense $0 $250

continued


18

A Taste of FAS 123R Dividends and DEUs

– If dividends are not paid on restricted stock during vesting period, then reduce fair value by present value of expected forgone dividends

– If dividends are paid, then fair value is not reduced– If awards do not vest and dividends are not returned, the

payments are reflected as compensation expense– Dividend equivalents receive the same treatment


Dividends and DEUs Not Recognized Not Recognized

continued


19

A Taste of FAS 123R Dividends and DEUs

Example

1 share of restricted stock granted at $10 with one year vesting $1 dividend payment expected

Dividend Paid and RS Vests

Dividend Paid and RS Doesn’t Vest

Dividend Not Paid on RS and RS Vests

FAS 123R Expense

$10 $0 $9

Other Comp. Expense

$0 $1 $0

continued


20

How’d That Happen? Negative Numbers

– The cause here was a share-based plan that settled in cash as mark-to-market accounting can create negatives due to stock price declines - FAIR GAME; Weird and Weirder Numbers on Pay Reports, NY Times, 3/11/07

– Example: Executives permitted to reinvest bonus into deferred share units whose value is based on company stock but is settled in cash. Such plans might be perceived positively as they align executive/shareholder interests

(2) Dollar amounts in the Stock Awards column reflect the compensation expense/(income) recognized for deferred share units during the 2006 fiscal year in accordance with SFAS 123R, “Share-Based Payment.” (3) The Company has recorded the intrinsic value of these options as a liability using variable plan accounting. The liability is expensed over the vesting period and re-measured at each reporting date to reflect the current intrinsic value because options can be settled in a cash amount equal to the difference between the market price of the shares underlying the option and the exercise price of the option.

– Note: no negatives would appear if full grant date value is shown (9/26/06 rule)


21

How’d That Happen? Big Numbers

– The other side of the coin: executive is retirement eligible and company adopts a share-based plan that will settle in cash and stock price rose during the year

2 The SEC rules require that the amounts in this column reflect the 2006 accounting expense incurred by the Company inaccordance with SFAS 123(R) for the PSUs and RSUs granted to the named executive officers. Because all the namedexecutive officers are retirement eligible, the Company is required to include in these amounts the entire expense of the 2006PSU and RSU awards. In addition, because the 2006, 2005 and 2004 awards are payable in cash, the Company is also required to include in this amount for 2006 any increase or decrease in the price of ______ stock and any dividend equivalents accrued with respect to these awards. The amounts in this column do not represent the grant date fair value of the 2006 awards granted, nor the amounts that will necessarily be paid to the named executive officer.


22

How’d That Happen? Big Numbers

– Example: Executives receive RSUs settled in cash, but the plan requires retention until the executive’s retirement

The Summary Compensation Table columns include the Financial Accounting Standards Board Statement No. 123(R), “Share-Based Payment” (FAS 123(R)) expense recognized by the Company in the year for all outstanding stock and option awards, which, because of the “hold-until-retirement” feature of our restricted stock/restricted stock unit programs, can be a substantial amount. Because we require our executives to hold restricted stock and restricted stock unit awards that have performance-vested until they retire, any appreciation in our stock price during a given year results in the Company recognizing the value of such appreciation with respect to certain previously-earned awards in its financial statements, and therefore, in the Summary Compensation Table.


23

How’d That Happen? SERPs

– Pension values will increase on a steep slope until the NEO’s retirement– Changes in actuarial value are reported in column (h) based on FAS 87

reporting assumptions: The change in value due to an additional year of service, compensation

increases (decreases), and plan amendments (if any); and The increase (or decrease) in value attributable to interest

– Example: SERP for incoming CEO to provide a $5 million present value SERP benefit in 10 years at age 60


(a)

Year

(b)

Salary($)

(c)

Bonus($)

(d)

StockAwards

($)

(e)

Option Awards

($)

(f)

Non-Equity Incentive

Plan Comp($)

(g)

Change in Pension and

NQDC Earnings

($)

(h)

All Other Comp

(i)

Total($)

(j)

PEO 2007 $205,745

PEO 2016 $1,034,272

continued


24


– There are situations where the Pension values will decline

“Total Compensation. Total compensation as reported in the Summary Compensation table decreased 21% from 2005 to 2006 for listed officers, primarily because of the decline in incentive cash compensation and the decrease in reported pension plan benefits. While the change in reported pension values decreased sharply, the reason for the decline was that the total value of the tax-qualified pension plan arrangement was reported in 2005 because this was the year the arrangement was established, and only the change in the value of this arrangement from the prior year was reported in 2006.

continued


25


– Alternative: grant Career Service Shares with a delayed vesting date: – Stock grants reported in column (e) based on FAS 123R financial

statement value amortized over vesting schedule– Example: Grant $2.5 million of restricted stock that vest in 10 years at age

60. Assumes stock price doubles in value by December 31, 2016. Total amount reported will equal $2.5 million – much less than the amount that would have been reported in column (h)


(a)

Year

(b)

Salary($)

(c)

Bonus($)

(d)

StockAwards

($)

(e)

Option Awards

($)

(f)

Non-Equity Incentive

Plan Comp($)

(g)

Change in Pension and

NQDC Earnings

($)

(h)

All Other Comp

(i)

Total($)

(j)

PEO 2008 $250,000

PEO 2016 $250,000


26

Comparing SERPs to Career Service Shares

SERPs Career Service Shares

Summary Compensation Table (SCT) Value

Change in pension values disclosed on the SCT tend to increase from year to year as executive nears retirement

Value disclosed on the SCT is based on the grant date stock fair market value, amortized over the service (vesting) period, without taking into account future increases in stock value

Proxy Values on Other Tables

Entire accrued value of the SERP to be disclosed on the Pension Table, whether or not vested, creating a perception of high dollars provided to executives

Disclosed based on number of shares outstanding. Potential dollar value of payment would need to be separately calculated

NEO Determination

Change in Pension Values are excluded in determining whether an executive is an NEO

Value disclosed on SCT is included in determining whether an executive is an NEO


27

Comparing SERPs to Career Service Shares

SERPs Career Service Shares

“At Risk” Pay Perceived as providing fixed pay disconnected from the performance of the executive or the company

Are “at risk” both because of future cliff vesting and potential fluctuations in stock values

Accounting Costs

Tend to be volatile costs due to discount rate changes and compensation increases/decreases

Will remain steady over the vesting period as the fair value at grant date will not be adjusted for stock price increases

Alignment With Shareholders

Arguably, little alignment with shareholders

Increases the portion of total compensation that is based on creating shareholder value through stock value appreciation

Retentive Value

Depends on vesting: less where vesting is same as qualified plan than where vesting is delayed until or near retirement age

Arguably, improves retention of management by increasing the portion of compensation that management "leaves on the table" if employment is voluntarily terminated


28

How’d That Happen? The Case of the Missing Corporate Income Tax

– The WSJ reported that many “profitable” tech companies pay lower corporate income tax than initially claimed for financial statement purposes - Tech Titans' Tax Picture Is Clouded by Options, C1, April 15, 2007

– When estimating the future tax benefit of option grants, the WSJ determining that several tech companies assume a higher tax rate than their true effective tax rate

According to WSJ, Google assumed an effective tax rate of 23% even though appreciation in stock value generated a high tax deduction for options exercised and RS vested that, in turn, reduced its tax rate to 8.8%

– In accounting lingo, there is a book-tax difference between the deferred tax asset created at the time the stock option is awarded (based on the Black-Sholes value) and the actual tax deduction later taken

– The FASB thoroughly vetted this issue and decided generally not to permit companies to recognize expenses or income related to true-ups between book-tax differences


29

How’d That Happen? The Case of the Missing Corporate Income Tax

– Hearing held by Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations on June 5th

– Reviewed nine companies and determined $1 billion more in tax deductions than booked expenses, had FAS 123R been in effect from 2002 to 2006.

– Chairman Levin’s position: Compensation committees are aware of the potentially "whopping tax

deduction" and use it as an incentive to grant a higher number of options to executives

Because options are not subject to 162(m), he argues that taxpayers "subsidize millions of dollars in executive pay“

He also believes that the book-tax difference is fueling the increasing gap between executive pay and that of the average worker.

– Legislation is expected to be proposed in the fall to match the tax deduction to the same year expenses are shown on a company’s books

– Issues to be resolved: What are the revenue estimates? How to transition in for existing grants? How are performance vested options and cash-settled SARs treated? Would this apply to restricted stock and RSUs?

continued


30

How’d That Happen? Grant Date Accounting and Negative Discretion under

Section 162(m)– A “grant date” cannot occur until employee and employer have a

mutual understanding of the key terms and conditions of the award (Example: the number of shares to be granted)

– Under a “negative discretion” 162(m) plan with performance shares, it might be argued that the grant date does not occur until the compensation committee determines the number of shares that will be paid

– Thus, the grant date doesn’t occur until after the performance period concludes, making all the shares subject to variable accounting

– Better view among the accounting firms is there is no bright line test and each case is evaluated on a facts and circumstances basis


31

One More Thing Financial Interpretation No. 48, Accounting for Uncertainty

in Income Tax– Companies required (generally as of 1/1/07) to create more

extensive disclosures about the tax positions the company is taking

– An estimate is also required of how the denial of a tax deduction could affect the future cash position of the company

– Companies have always been required to estimate a tax cushion, but the new rules require far more extensive disclosures than in the past

– SEC staff says that it expects to see some changes in the contractual obligations table of the MD&A section of the 10-K, resulting from companies’ analysis of outstanding tax positions in accordance with the new rules

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Watsonwyatt.com 2007 ALI-ABA Executive Compensation Course of Study: Strategy, Design, and Implementation What Does Accounting Bring to the Table? Nick