Financial Reporting Presents: Share-Based Payment Transactions: Frequently Asked Questions

Financial Reporting Presents: Share-Based Payment Transactions: Frequently Asked Questions

Agenda Current Developments Accounting Valuation Income Taxes Questions & Answers

Keep In Mind This webcast is based on the observations of Deloitte & Touche LLP representatives. Although we believe these slides to be accurate, we cannot represent that they are complete or without error This webcast does not provide official Deloitte & Touche interpretive accounting guidance Objective: At the end of this webcast, participants should be able to identify and understand certain key implementation issues of FASB Statement No. 123 (revised 2004), Share-Based Payment

Current Developments

Current Developments Staff Accounting Bulletin No. 107, Share- Based Payment SEC Deferral in April 2005

SEC Defers Effective Date Statement 123(R) is now effective the beginning of the fiscal year beginning after June 15, 2005 [instead of at the beginning of the first quarter after June 15, 2005] NOTE: The deferral does not affect companies with June, (July to August) fiscal year ends

Revised Effective Dates Year End January 31 February 28 March 31 April 30 May 31 June 30 July 31 August 31 September 30 October 31 November 30 December 31 Public Company February 1, 2006 March 1, 2006 April 1, 2006 May 1, 2006 June 1, 2006 July 1, 2005 August 1, 2005 September 1, 2005 October 1, 2005 November 1, 2005 December 1, 2005 January 1, 2006 Small Business Issuer & Nonpublic Company February 1, 2006 March 1, 2006 April 1, 2006 May 1, 2006 June 1, 2006 July 1, 2006 August 1, 2006 September 1, 2006 October 1, 2006 November 1, 2006 December 1, 2006 January 1, 2006

Polling Question #1 Does the deferral of the effective date of Statement 123(R) provide public registrants enough time? No, more time is needed Yes, the additional six months for calendar yearend companies is enough My company is a non-calendar year end, our effective date remains unchanged by the deferral No opinion/no answer

SAB 107 Share-Based Payment Is there a preferable valuation method? No Can a company change its valuation method? Yes Can stock compensation expense be shown as a single line item on the Income Statement? No

SAB 107 Share-Based Payment Can a company s disclosures exclude the effects of stock-based compensation? Carefully Can a company accelerate vesting of underwater options prior to adopting? Yes Are there transition issues when a company is going public? Yes

Polling Question #2 Does your company plan on early adopting (e.g., in the fourth quarter of 2005) the requirements of Statement 123(R)? No, our company does not plan on early adopting Statement 123(R) Yes, our company plans on early adopting Statement 123(R) Our company has already early adopted Our company is still analyzing the possibilities No opinion/no answer

Accounting

Frequently Asked Questions Recognition Is compensation cost always recognized over the stated vesting period? Generally, yes but be mindful of the following: Derived or implied service periods Non-substantive vesting terms Retirement eligible employees Record compensation cost immediately, if issued to retirement (or early retirement) eligible employees rather than the stated vesting period Record compensation cost over the period from the date of grant until the employee becomes retirement (or early retirement) eligible rather than the stated vesting period

Frequently Asked Questions Recognition How do non-compete provisions included in a share-based payment award impact the accounting? Extends the service period Recorded as a contingent gain, if and when, it occurs

Frequently Asked Questions Recognition Should a company capitalize stock-based compensation cost as part of an internally constructed asset? Yes. Under Statement 123 companies were not precluded from capitalizing compensation cost in their pro forma footnote disclosure Statement 123(R) indicates that companies should capitalize stock-based compensation cost as a cost to acquire or construct an asset (e.g., inventory or fixed asset)

Frequently Asked Questions Recognition If a company had not previously capitalized stock-based compensation cost as a cost to acquire or construct an asset, how would it transition to Statement 123(R)? Prior reported amounts generally should not be changed

Polling Question #3 Do you believe the capitalization of stockbased compensation will be significant? No, our company does not expect the amount of stock-based compensation cost capitalized to be significant Yes, our company expects the amount of stockbased compensation cost capitalized to be significant Our company has not completed the analysis of the capitalization of stock-based compensation No opinion/no answer

Frequently Asked Questions Classification Are share-based payment awards classified as liabilities accounted for differently than equity awards? Yes

Frequently Asked Questions Classification Are all share-based payment awards that would have been classified as a liability under other GAAP considered a liability under Statement 123(R)? If considered liability under other GAAP then considered a liability under Statement 123(R) Exceptions Equity treatment permitted Certain put features Awards that permit minimum statutory tax withholding requirements Registered share requirements under EITF Issue 00-19 Certain dual indexed awards Awards with an exercise price in a foreign currency

Frequently Asked Questions Classification Are all share-based payment awards that would have been classified as equity under other GAAP considered equity under Statement 123(R)? Exceptions Liability classification under Statement 123(R) Substantive liabilities - company has a past practice of settling equity awards in cash

Frequently Asked Questions Classification If a share-based payment award qualifies for one of the exceptions, how does a company account for an award that is no longer subject to the employee providing employee service? If exercise period extends beyond 90 days subsequent to termination of employment, certain features may cause the award to become a liability Requires consideration of: Exercise periods upon termination of employment within the control of employee (e.g., quit without good reason ) When put features extend beyond termination of employment Less obvious put features such as statutory minimum tax withholding obligations

Frequently Asked Questions Classification What is the status of the Proposed FSP EITF 00-19a?

Polling Question #4 What is your company s view of Statement 123(R) s requirement to re-assess awards that are no longer subject to the employee providing employee service? Agree with the issuance of FSP EITF 00-19a The FASB should amend Statement 123(R) to remove the reassessment The reassessment will not affect my company No opinion/no answer

Frequently Asked Questions Other Now that compensation cost will be reported in the financial statements, how does a company compute diluted earnings per share using the treasury stock method?

Frequently Asked Questions Other Example Assume the following: Company has net income of $5 million for the year ended December 31, 2007 Company has 1 million common shares outstanding for the entire year Company has 50,000 stock options that were granted on January 1, 2007 and vest on December 31, 2008 The stock options have an exercise of $10 per option The stock options have a grant-date fair value of $2 per option The average price of the Company s stock for the year ended December 31, 2007, was $15 per share The Company s combined statutory tax rate is 40 percent

Frequently Asked Questions Other Earnings per share Example (cont d) Shares to be issued upon exercise of stock options outstanding as of December 31, 2007 Proceeds: Exercise price (50,000 options $10 exercise price) Average unrecognized compensation cost: [(Beginning of year unrecognized compensation cost ($100,000) + End of year unrecognized compensation cost ($50,000)) 2] Excess tax benefit [(($15 - $10) - $2) 50,000 options] x 40 percent Total hypothetical proceeds Average stock price Number of shares reacquired ($635,000 $15) Net number of shares issued (50,000 42,333) Weighted average number of common shares outstanding during the year basic Shares included in diluted EPS computation Net income available to common shareholders Diluted EPS 50,000 $500,000 $75,000 $60,000 $635,000 $15 42,333 7,667 1,000,000 1,007,667 $5,000,000 $4.96

Frequently Asked Questions Other Upon adoption of Statement 123(R), can a company change their policy of recognizing compensation cost for share-based payment awards issued prior to the adoption of Statement 123(R) with a graded vesting schedule? No Not permitted to change the method of attribution upon adoption of Statement 123(R)

Frequently Asked Questions Other Upon adoption of Statement 123(R), can a company change their policy of recognizing compensation cost for share-based payment awards issued after the adoption of Statement 123(R) with a graded vesting schedule? Yes Company required to make a policy decision at the date of adoption of Statement 12(R) Record all newly issued awards on a straight-line basis or on an accelerated basis (following the example in Interpretation 28)

Frequently Asked Questions Other Can a company recognize compensation cost for share-based payment awards with subjective performance conditions (e.g., performance conditions based on employee performance ratings)? No Grant date has not been established Compensation cost not measured until the grant date

Frequently Asked Questions Other Has a grant date occurred if the company has not received Board approval? No Awards are not considered granted if they are subject to Board approval and the approval has not been obtained

Valuation Considerations

Implementation Who should be on the Statement 123(R) valuation project team from the company s perspective? Often led by Corporate Accounting, Finance Directors on behalf of the CFO Also involves: Treasury Human Resources Accounting Tax

Implementation What is the typical timing of a project? 6-8 full project weeks across 2 quarters Biggest hold-up: grantee data; and within that, the alignment of vesting, grant information, transactions, and market data by date, group, and grant Biggest discussions: The company does not believe this volatility The company does not believe this expected life The company does not believe this valuation

Model Inputs What challenges are encountered when working with optionee data? Number of options issued / exercised International employees Mergers and acquisitions

Model Inputs What data can a company use for expected volatility? Start with option market data Validate with history Focus on liquidity of market data Long term volatility is a formula based on observed market practice: biggest issue is whether the company believes it and can support it

Implementation Can a company just use the SAB 107 simple method for expected term? Not exactly: still must rely on management s judgment Some indications No history Reorganized, coming out of bankruptcy, MBO, IPO, etc. Prospective grants are substantively different from history A company may be hard pressed to support the use of the simple method when it has reliable grantee exercise and cancellation data that applies to prospective grants, and the company has already performed valuations with guideline companies

Model Inputs Is expected life an input to the lattice model? No: it is an output of the lattice model Lattices can calculate all of those time intervals during which an option remains alive, i.e., when not exercised or cancelled, given the probability of stock price movements Expected life (i.e., expected term) is an input to the Black-Scholes model Use full grant histories to develop exercise and postvesting cancellation durations as a calculation of weighted average life Use partial grant histories with great care due to the unvested grant assumption (do you choose full contractual life or some mid-point?)

Model Inputs Can a company use peer data? Yes, and a company should Use for volatility and exercise profile data analysis Be guided by hierarchy of data reliance: Start with market data, and internally available data resources Refer to peer/guideline companies Refer to surveys (e.g., bank, consulting, and academic) Rely on models to confirm statistical hypotheses about trends, inclusion of factors

Model Choice Can a company switch from Lattice to Black- Scholes? Definitely from Black-Scholes to Lattice Not easily from Lattice to Black Scholes; some indications: Grant history is unreliable Forward business has changed substantively New grants do not look like old grants

Model Choice Does a company have to use lattice, or can it use Black-Scholes? It is always management s judgment Here are some indicators If a company uses Black-Scholes, did it at least try to use, and at least study the use of lattice? If so, then a company can reasonably be seen to have an informed model choice decision, the quality of which would be subject to further testing All lattice inputs are substantively unreliable. This may also call into question your Black-Scholes inputs as well.

Model Choice How can a company value a performance based award with contingent event triggers for vesting and award? This is probably a hybrid share and option award (paragraphs 21 and 22) Value using a lattice or Monte Carlo tree that triggers an award when volatile factors reach requisite levels This is not simply a stock price times a probability of vesting valuation

Polling Question #5 Which pricing model does your company plan to use for valuing share-based payment awards under Statement 123(R)? Black-Scholes-Merton Lattice Not yet considered model type No opinion/no answer

Income Tax Accounting

Income Tax Accounting What are the basic income tax accounting rules under the new standard? For nonstatutory options (NSOs) and most other equity-based awards, the book expense is a temporary difference For statutory awards (incentive stock options or ISOs and qualified Employee Stock Purchase Plans or ESPPs), the book expense is a permanent difference. A tax benefit can be recorded only if and when there are disqualifying dispositions For both types (nonstatutory and statutory), excess tax benefits (aka windfall benefits ) are credited to equity Tax deficiencies are a different story

Income Tax Accounting What are tax deficiencies and how are they treated? Tax deficiencies (aka shortfalls) arise when the tax deduction is less than book expense for nonstatutory awards For example: Fair value of NSO is $20; spread on exercise is $12 No DTA for statutory awards, so no deficiencies Tax deficiencies are written off (debited) against excess tax benefits, either current or accumulated in the companies APIC or windfall pool If there are no excess tax benefits, then the shortfall increases income tax expense

Income Tax Accounting Example: Tax Deduction < Book Expense Assume Fair Value of 1,000 options is $10,000, tax rate is 40%, and spread on exercise/disqualifying disposition is $5,000 Type of Option: NSO ISO/ESPP Book Option Expense 10,000 10,000 Tax Benefit over vesting pd (4,000) N/A Tax Benefit upon DD (40% of 5K) N/A (2,000) After Tax Cost 6,000 8,000 Debit/(credit) to APIC 2,000** N/A ** Assumes company has sufficient APIC pool to absorb the $2,000 tax deficiency when NSO is exercised

Polling Question #6 To what extent will the adverse tax accounting implications for statutory options impact your company's use of incentive stock options? No Impact Some Impact Significant Impact Not Applicable/No Answer

Income Tax Accounting How is the APIC pool calculated? Under Statement 123(R), all companies need to compute their pool of excess benefits as though they had adopted Statement 123 as of its original effective date Recompute for all awards granted in years beginning after 12/15/94 Compare actual tax deductions to the book expense under SFAS 123, as calculated for the income statement or for footnote disclosure Only exclude awards not included under Statement 123(R) s scope, such as ESOPs

Income Tax Accounting Are there other complications involved in calculating the APIC pool? For full history, have to compute period by period. Start over from zero anytime APIC pool is depleted (i.e. don t go negative) ISOs and qualified ESPPs can only increase APIC pool Overseas options Mergers, acquisitions, and divestitures since 1995 Option exchanges and other modifications Other stock-based awards With and without calculation for other attributes

Income Tax Accounting When is the APIC pool available? Excess tax benefits are only available to offset deficiencies once they have been realized via a reduction in taxes payable See par. A94, footnote 82 of Statement 123(R) Also, par. 63 and par. 81 Unclear as to Board s requirement that excess benefits be realized pursuant to Statement 109 See example on next page

Income Tax Accounting Example: When are excess tax benefits realized? Current year book and tax income $5 M Current year option tax deductions $5 M NOL C/F (no option deductions) $8 M Can excess benefits that are part of the current year option deduction be credited to APIC now since they offset taxable income on tax return before NOL carryforward is used? Or, under Statement 109 ordering rules, does the entire NOL carryforward need to be used before excess benefits from options are deemed to be realized pursuant to Statement 109? Does existence of valuation allowance on NOL carryforward matter?

Income Tax Accounting Should companies reverse previously recorded APIC for excess tax benefits that are not yet realized under the new standard? No adjustment is needed to reverse excess tax benefits previously recorded. However, on a goforward basis, companies should not record DTAs and APIC for excess benefits until they are realized pursuant to Statement 109 See par. B217 and par. 81

Income Tax Accounting What entries should a company make to record the available APIC pool? No entries are required, unless a company chooses to reclassify a portion of its APIC to a new account From the October 6, 2004 Board meeting: No adjustment related to that amount would be made to additional paid-in capital at the effective date; however, enterprises would consider that amount in determining the amount of deferred tax asset that may be written off to additional paid-in capital upon settlement of an outstanding award

Income Tax Accounting Does a company need to disclose its available APIC pool? No, the SEC confirmed (in SAB 107) that companies do not need to disclose the amount of APIC that is available to offset future tax deficiencies

Polling Question #7 Will your company take advantage of the SEC's guidance stating that a company only needs to compute its available APIC pool when it has future tax deficiencies? Yes No, we want to know what our available pool is when we adopt Statement 123(R) No, we may not have the pool determined as of the date we adopt, but we won't wait till we have deficiencies. No opinion/no answer

Income Tax Accounting Do companies have to track tax effects on an option-by-option basis? Yes, in order to determine whether there is a deficiency or an excess benefit. Footnote 31: If only a portion of an award is exercised, determination of the excess tax benefits shall be based on the portion of the award that is exercised In addition, for statutory awards, companies must determine how much of the tax deduction can be recognized in the income statement and how much, if any, is credited to APIC as an excess tax benefit

Income Tax Accounting Example of concept under footnote 31: Assume fair value book expense for NSO on 100 options equals $1,000, and tax rate is 40%. DTA equals $400 ($1,000 x 40%) Assume 25% of options are exercised in subsequent year for tax deduction of $1,000 Only reverse 25% of the DTA. Remaining tax benefit of $300 is credited to equity. If stock price declines and options expire, company will have a deficiency for the remaining $300 If these were ISOs or ESPPs and the employee made a disqualify disposition for 25% of the option, company would only record up to $100 of tax benefit [(25% x $1,000) x 40%]

Income Tax Accounting Summary How will expensing impact my effective tax rate? Action or event Expensing non-statutory awards Deficiency on non-statutory award Expensing statutory awards Disqualifying dispositions Overseas awards Cancel vested non-stat. awards Forfeitures Section 162(m) limitation Impact on ETR Generally none None, w/apic pool. Increase otherwise Increase Decrease It depends Same as deficiency Generally none Generally increase

Questions

Publications Heads Up on Statement 123(R) http://www.deloitte.com/dtt/cda/doc/content/us_assur_h eadsupsharebasedpayment(2).pdf Heads Up on SAB 107 http://www.deloitte.com/dtt/cda/doc/content/us_assur_h eads%20up%20-%20volume%2012%20issue%203.pdf Dbriefs Webcast January 5 th 2005 http://webcasts.deloitte.com/dbriefs_fr_archives/01050 5_Event10120/files/lobby.html