Stock Compensation Plan Design Implications for Companies Adopting FAS 123 Recently, several companies including Coca-Cola, General Electric and General Motors have announced that they will adopt FAS 123, Accounting for Stock-Based Compensation, to recognize expense in the income statement related to stock options (see HR Insight 02/18 dated 8/14/02). We expect many more companies to make similar changes in their accounting policies in either 2002 or 2003. Moreover, the FASB has begun a fast track project expected to amend FAS 123 by this year-end to allow greater flexibility and choices in the method of adoption. This may also encourage more companies to elect to adopt FAS 123 and expense the costs of stock-based compensation. Most companies have designed their stock-based compensation programs to take into consideration the accounting rules under APB Opinion No. 25, Accounting for Stock Issued to Employees. For those now adopting FAS 123, a significant array of alternative plan designs should now be considered. This HR Insight discusses these plan design alternatives and other strategies that may be beneficial in light of the adoption of FAS 123. In recent years, the use of stock-based incentives has expanded significantly, reflecting efforts of boards of directors and compensation committees to link compensation with shareholder return. Because they accounted for options and other forms of stock-based compensation under APB 25, most companies use fixed plain-vanilla stock option plans, which generally result in no accounting expense. For the most part, companies avoided performance-based plans and other designs that may result in significant charges to income -- variable plans under APB 25 -- even if the performance-based or other designs would create a greater strategic alignment with shareholders. However, where companies elect FAS 123 accounting treatment, all stock-based plans not paid in cash result in fixed expense. With the accounting playing field leveled, these companies can place greater emphasis on strategic issues when designing their stock incentive plans. DEVELOPING AN ACTION PLAN As companies consider adopting FAS 123, a number of key factors should be addressed, as presented in the action plan in Exhibit 1. This plan will assist companies in making informed decisions about current and future stock-based programs. The remainder of this HR Insight discusses the key components of this action plan in detail. Exhibit 1: Action Plan for Strategic Plan Design Review company tactical and strategic goals, integrating the objectives of the long-term stock-based program with company goals. Review current plan provisions. Assess the impact of adopting FAS 123 on current stock-based program. Evaluate plan design alternatives. Assess the financial reporting and tax implications of plan design changes, as well as the potential impact on executives and employees. Consider the reaction of shareholders, analysts and the media to any plan changes. Develop implementation and communication strategies as soon as program changes are determined.
DETERMINING A COMPANY S OBJECTIVES Before addressing plan design changes, management and the compensation committee should determine the role of a stock-based incentive program in achieving company objectives. While objectives may change over time, establishing an overall compensation philosophy and determining the role of stockbased plans are necessary to evaluate alternatives to the current plan design. Exhibit 2 presents several important questions to consider in reviewing stock-based plan objectives. Exhibit 2: Establishing Stock-Based Program Objectives How do stock-based plans fit into the company s overall compensation and benefits package for executives and employees? How is the current program viewed by stockholders, the board of directors (especially outside directors), executives, other employees, and the media? What impact would plan changes have on these perceptions? To what extent should accounting, financial reporting and disclosure considerations affect plan design? Should the current program remain unchanged after adopting FAS 123, despite possible negative accounting implications? Will changes to the program strengthen the alignment between stockholder and executive/employee interests? Should stock-based plans be limited to executives, extended to middle or lower management, or broadened to include all employees? How will executive/employee recruitment, retention and early retirement be affected by changes to the current program? Should the program include stock retention incentives or mandatory holding requirements? How will executives/employees be taxed, and what tax deductions will the company be allowed under possible plan design changes? When should plan design changes be adopted? How should they be implemented and communicated? Observation: Developing and implementing effective plan design strategies usually requires a high-level task force with representatives from financial, human resource, tax and legal management. The team should be established early and begin by evaluating broad policy objectives and long-range goals of the program, and coordinating its activities with the company s board of directors, particularly the compensation committee. ASSESSING THE FINANCIAL STATEMENT IMPACT OF ADOPTING FAS 123 Once strategy and design objectives are established, the company should understand how the adoption of FAS 123 would impact its current stock-based programs and the company s financial statements. Understanding the potential impact on current and future costs is important in developing a stock-based program that will be appropriate for the company and provide adequate incentives and rewards to executives/employees. Companies should review plan provisions and determine the potential cost of recent stock-based awards -- and expected future grants -- if the adoption takes place. In assessing the possible impact of adopting FAS 123, companies should be aware that FAS 123 currently allows only a prospective transition approach, with expense measured only for new grants or modifications after the beginning of the year of adoption. However, under a new FASB proposal, the FASB voted on August 14, 2002 to issue an exposure draft that, if adopted in final form, would expand the transition choices to allow the following alternatives: 1. Prospective Same as currently required by FAS 123, but FASB would clarify that pro forma net income and EPS would need to continue for the preadoption grants that continue to vest in the current and future years. 2. Modified Prospective Expense new grants plus the post-adoption attribution of expense related to pre-adoption grants (no pro forma disclosure would be needed). HR Insight 02/19 August 20, 2002 2
3. Limited Retrospective Restatement of all prior period income statements presented (future expense same as Alternative 2. above). The FASB also proposed to amend the disclosure rules in FAS 123, as follows: Companies would be required to indicate in the accounting policy footnote to the financial statements which of the above three transition alternatives was selected in adopting FAS 123 or whether the company retains the APB 25 accounting method. Disclosure of pro forma net income and EPS would also be moved from the stock option footnote into the accounting policy footnote. Starting in the first quarter of fiscal years beginning after December 15, 2002 (e.g., the first quarter of 2003 for calendar year-end companies), quarterly disclosure of any proforma net income and EPS would be required, and quarterly disclosure of recognized FAS 123 expense may also be required. While a final FASB statement is not expected until later this year, companies should assess the impact of the above three proposed transition alternatives and the new disclosure proposals in considering FAS 123 adoption. Observation: To perform the necessary expense estimates, companies will need reliable data and assumptions. Accordingly, companies should assess their available data on forfeitures before vesting, exercise term, stock price volatility, option conversion due to equity restructurings (e.g., a spin-off), etc., and the assumptions used previously under FAS 123. For some companies, systems changes may be necessary to facilitate data collection. In addition, assumption changes may be warranted due to a more thorough analysis of historical data and future expectations. For example, the expected term assumption -- a key driver of Black-Scholes value -- may not reflect current expectations, U.S. versus global employee differences, and other factors. EVALUATING ALTERNATIVE PLAN DESIGNS If the company adopts FAS 123, no simple solutions will be available to avoid expense charges for stock-based incentive programs. However, a number of alternatives could mitigate the impact of the accounting standard while providing executives and employees with meaningful rewards that are linked to shareholder interests. Modifying Stock Option Plans. Depending on their objectives, companies can modify stockbased plans in various ways, allowing them to continue to grant stock options while minimizing possible accounting charges. Each proposed change should be modeled to assess its effect on future expense. A company may decide, for example, that a minimal reduction in expense may not be worth the negative impact on employee and shareholder relations. The following modifications may minimize expense while continuing to motivate employees. Lengthen vesting periods/shorten options terms. Since FAS 123 requires the expense measured at grant date to be spread over the vesting period, stock options that vest over relatively short periods (e.g., one year) could trigger a major expense charge over a short time. Companies may consider lengthening the vesting period to spread the compensation expense over a longer period of time. Longer vesting periods may also potentially increase the forfeiture rate, further lowering the annual expense charge. However, longer vesting periods will generally extend the expected exercise term, increasing the option s value. To understand the specific impact of such changes, financial modeling is necessary. For example, assume that a company grants stock options with an exercise price of $40 (equal to stock price at grant date) and that options vest in one year. These options have a Black-Scholes value of $9.10 per share, assuming a two-year expected exercise term, 40% volatility and 1% dividend yield. If the company changes the vesting period to four years, and this change causes the expected term to increase to six years, the Black-Scholes value would increase to $16.29 per share, a 79% increase in option value. However, the $16.29 value would be amortized over four years, or $4.07 per year, instead of $9.10 amortized over one year. HR Insight 02/19 August 20, 2002 3
Shortening the maximum term (e.g., from ten years to five) may also reduce option value and expense, provided that actual exercise patterns are altered by this change. For example, if a company s 10-year options are typically exercised after four years, reducing the maximum term to five years would generally have little or no impact on option value and expense. Consideration should also be given to shortening the maximum term for some groups (e.g., executives) but not others. From a human resource perspective, extending vesting may increase retention of key executives, although longer vesting periods or shorter option terms may not be well received by executives or employees. Most importantly, management should consider how changes would relate to the company s overall business plan and performance goals. Adopt performance-related options. Relating the vesting, exercise price or grant size to performance will combine stock programs with performance incentives that are attractive to shareholders. Performance-related plans, subject to less favorable accounting under APB 25, are measured at grant date as are traditional fixed plans under FAS 123. Also, performance-related plans have additional advantages under FAS 123. For example: With performance-related plans, forfeitures due to failure to meet performance goals (other than a goal tied to the company s stock price) will not result in compensation cost. Although it would be necessary to true up for actual attainment of the performance goals, only those options that the employee ultimately vests in will incur an accounting charge. This may be an important advantage to companies over options with no performance features. Unlike underwater options that have less value to the executive, but incur substantial accounting charges under FAS 123, nonstock price performance options result in FAS 123 expense only if performance goals are achieved and the employee receives value. Performance-related plans are popular with shareholders and serve to strengthen the link between executive and shareholder interests. Observation: Expense for performance options is not reversed under FAS 123 for failure to meet a performance goal that is tied to the company s own stock price or total shareholder return, or is based on how the company s stock performs against a peer company or index. However, stock-based performance options will generally have a lower fair value and expense under FAS 123 than traditional non-performance related options. Reduce options granted/reevaluate pay-mix. Companies may consider reducing the number of options granted to all employees or reducing the size of awards for some or all employees. In addition, the company may want to consider the components of the pay-mix. While keeping equity as a component, it is important to make certain that proper weightage to other components is also provided. In this regard, reducing grant size will reduce FAS 123 expense, but if employees demand other compensation changes, overall costs may be less affected. Alternate option grant cycles. Considering potential expense under the prospective transition approach now called for by FAS 123, companies could grant options every other year rather than annually. For example, a company may consider granting two years worth of options in late 2002, then adopt prospectively in 2003, thereby avoiding expense in 2003. However, such expense would need to be reported in pro forma disclosures. In addition, a mechanism to provide equivalent option value for new hires will need to be put in place. Grant premium options. Options in which the exercise price is higher than the stock s market value on the date of grant would have a lower value than at-the-money options, as long as all other terms and assumptions remain constant. For example, the value of a $40 option (based on a four-year term, 40% volatility, and 1% dividend yield) would decrease from $13.11 to $10.70 if the exercise price was set at $48, or 20% above current stock price. Premium options, however, may increase expected term and option values, because longer exercise periods may be necessary before the stock option has value. Premium options provide executives with an added incentive to increase stock price, and may be viewed favorably by shareholders. From the employee s perspective, these options are less desirable than at-the-money options, so they may expect larger grants. HR Insight 02/19 August 20, 2002 4
Observation: Under FAS 123, the value of a stock option is not adjusted for actual term when the options are actually exercised. In addition, if an option expires unexercised, the fact that an option is worthless or underwater and not exercised does not result in a reversal of FAS 123 expense. If a company were to set a high premium exercise price, it would initially lower option value and expense, but if the premium caused the option to expire unexercised, the expense would not be reversed. Grant indexed options. Setting an indexed exercise price -- either to a fixed percentage (e.g., 5%) or to a published index (e.g., S&P 500) -- would generally decrease the option s value because it would be similar to a premium option in the majority of situations. As a result, compensation expense would be lower under FAS 123 than for the same number of options granted at-the-money. Indexed options are currently accounted for as variable plans under APB 25, because their exercise price is not generally known at the grant date. However, under FAS 123, indexed options would be valued at grant date. In down markets, indexed options can be very attractive to executives, because the executive may receive compensation for beating the index even if the company s stock price fails to grow. Issue mega-grants. Front-loaded options, megagrants, that cover several years option awards could be made in the year before prospective adoption of FAS 123. The exercise price could be set in tranches with different premiums applied to each tranche, e.g., 25% at the options at FMV, 25% at 115% of FMV, 25% at 130% of FMV, and 25% at 150% of FMV. Companies would need to explain the reasons for mega-grants in proxy statement disclosures and such plans might exhaust the existing option pool. In addition, pro forma net income and EPS would need to be disclosed related to grants issued before adoption of FAS 123. Revise broad-based plans. More and more companies are extending stock options to middle management or to all employees. Although many companies, employees, and shareholders have responded favorably to these broad-based programs, companies will need to assess their benefits in light of FAS 123, and potentially explore other alternatives. For example, companies may consider reducing the number of covered employees or the size of the grants in response to the increased compensation expense. Alternatives to Stock Options Currently, most alternatives to plain vanilla stock options result in expense under APB 25 and often that expense must be marked-to-market until vesting or exercise. Under FAS 123, alternatives to traditional stock options, such as performance grants, will receive more favorable grant date accounting. However, other alternatives, such as discounted employee stock purchase plans become less attractive. Companies may consider some of the following alternatives. Grant restricted stock. Restricted stock has not always been viewed as favorably as stock options, because under APB 25 the grant date price of the restricted stock award is recognized as expense over the vesting period. In addition, shareholders sometimes view restricted stock as a giveaway. Under FAS 123, both stock options and restricted stock grants would result in compensation expense. Restricted stock grants, however, may be more motivational to employees as they benefit from voting rights and dividends. In addition, restricted stock retains some value even when the stock price falls below the grant date price thus, retaining more retention and motivational power than an underwater stock option. Performance accelerators can also be added to restricted stock programs, whereby the restricted shares will vest after the required service period, or sooner if performance goals are met. Restricted stock is generally less dilutive than options in terms of overhang, because fewer shares are required to provide the same economic value, but the impact on diluted earnings per share may be similar. Grant performance shares. Performance shares that vest when performance goals are met may also be more attractive under FAS 123, because expense is measured at grant date similar to performance options discussed above. In addition, such programs are less dilutive than options, as fewer shares are required to provide the same economic reward. Issuing performance shares may reduce the potential charge to earnings under FAS 123 and result in fewer shares outstanding, affecting earnings per share. HR Insight 02/19 August 20, 2002 5
Provide Stock Appreciation Rights (SARs) settled with stock. SARs allow an employee to receive the appreciation on company stock without any cash investment. Appreciation may be paid in cash or stock; both are accounted for as variable plans under APB 25. Under FAS 123, cash SARs would continue to be treated as variable plans and expensed based on the amount of cash paid (i.e., the liability would be marked-to-market until paid). However, stock SARs payable in stock only, or regularly paid in stock, would have grant date accounting. In most cases, expense for stock SARs would be the same as stock options under FAS 123. Stock SARs can also eliminate the need for cash to exercise options, and encourage share retention, since no shares must be sold to finance exercise. Performance features may also be added and, similar to performance options, if performance conditions (not tied to the company s stock price) are not met, there would be no earnings charge. Executives may also prefer stock SARs to performance shares because they can control the timing of exercise. Revise Section 423 employee stock purchase plans. Stock purchase plans (Internal Revenue Code Section 423) allow employees to purchase company stock at a discount of up to 15%. Under current accounting rules, there is no expense charge, but FAS 123 eliminates this favorable treatment in most cases. Under FAS 123, not only the 15% discount is expensed, but since most plans have certain option-like features, fair value is measured using an option-pricing model, generally resulting in greater expense than just the 15% discount. Companies with Section 423 plans may wish to reexamine their plan provisions to minimize potential cost. Like broad-based plans, some alternatives include reducing the number of shares of stock that will be offered (while complying with discrimination rules for qualified plans), decreasing the discount, shortening the option term, or eliminating the plan altogether. Retention Devices Retention devices, such as the grant of restricted stock on exercise of options or reload options, have been designed to reinforce the link between executives and shareholders. Under FAS 123, however, some retention devices may have financial statement implications, such as the increased charge for options under a reload program. As a result, companies may choose to replace current retention devices or eliminate them. However, certain retention devices (e.g., restrictions on sale) may reduce option value and may be attractive to some companies. Restrictions on sale. The company may require the employee to hold the stock for some period of time (e.g., two years) after exercise of the option. While FAS 123 does not specifically address how retention features should be treated in measuring option value, some reduction in value may be appropriate. For example, if a company with a current stock price of $40 grants options with a six-year expected term, 40% volatility and 1% dividend yield, option value would be $16.29. If the company placed a two-year restriction on sale of stock after the option is exercised, expected term may be reduced to four years in consideration that the employee may exercise earlier if he or she has to hold the stock for two years, resulting in an option value of $13.11, a reduction of 20% to reflect the two-year sale restriction. Reload options. Reload programs provide for the grant of new options when the option exercise is financed with previously owned stock. Reload options are granted at current market price for the remaining term of the original option and enable executives to finance the exercise of their options without diminishing their stock ownership potential. Under APB 25, reload options are generally considered new grants, but with no expense because they are fixed plans. Under FAS 123, reload options would also be treated as a new grant, with an additional expense charge measured at the date of each grant. For example, assume that a company with a $40 stock price and initial option value of $9.10 (based on 40% volatility, 1% dividend yield and two year expected term) has a reload program that permits employees to exercise options approximately every two years. Under FAS 123, the effect over the 10-year period, assuming a $2.00 increase in stock price every two years and four reload grants, would result in a charge of $50.04 for the original grant and reload grants. Alternatively, the option value for a 10-year option without a reload feature would be $16.29 (based on a six year expected term) or 33% of the cumulative expense of the entire reload option grant. HR Insight 02/19 August 20, 2002 6
REPRICING UNDERWATER OPTIONS Since the FASB issued FIN 44, Accounting for Certain Transactions Involving Stock Compensation an interpretation of APB Opinion No. 25, variable accounting under APB 25 is required if stock options are repriced, or if the underwater options are effectively cancelled and new at-the-money options issued. As a result, most companies avoid repricing options, or use certain less favorable techniques to avoid the accounting charge such as cancelling the underwater options and waiting six months and a day to reissue new options. Under FAS 123, option repricing does not result in variable accounting. FAS 123 treats a repricing or a cancellation and reissuance as an option modification. Repricing an option (e.g., reducing a $40 exercise price to $20 to equal the current stock price) is accounted for under FAS 123 as follows: The fair value of the original option continues to be expensed over the remaining vesting period. The incremental fair value of the replacement or repriced option is measured at the repricing date and expensed over the remaining vesting period. This incremental value is based on the fair value of the new at-the-money option less the fair value of the underwater option measured on the repricing date. However, special rules must be followed for repricings that take place after adopting FAS 123 where the original grants took place before adoption. In these cases, the incremental value generally equals or is close to the fair value of the new at-the-money replacement option. In addition, special consideration should be given to more complex situations, such as cancelling an option and regranting after six months and a day. Observation: Because of the possible negative reaction of shareholders, analysts, and the media, option repricing should be considered very carefully, even though the accounting under FAS 123 might be more favorable than under APB 25. ISSUES RELATED TO GLOBAL STOCK COMPENSATION PROGRAMS The use of stock-based compensation has significantly expanded across the globe and has penetrated deeper into organizations. Companies having global broad-based plans have to be careful when implementing new equity plan designs as the effect may have various implications in different countries. The costbenefit of such plans needs to be assessed carefully and the importance of local culture and philosophies cannot be understated. Due diligence studies need to be done to assess the impact of any new or modified plan design in local jurisdictions including a review of the tax, regulatory and labor law aspects of the proposed plan. For example, granting restricted stock in some countries may alleviate exchange control restrictions, but cause securities law issues in some countries where it is illegal to hold foreign stock. A grant of premium stock options may be a problem in other countries where approval is required from exchange control authorities. Additionally, there may be labor law issues such as compliance, works council, and data privacy rules that need to be addressed, particularly where plans are being exchanged for less attractive plans. Acquired rights may also become an issue where performance related plans may cause the benefit to be categorized as salary for calculation of severance/retirement benefits. Moreover, local country tax issues should be addressed regarding any new plan design, while assessing whether qualified plans with beneficial tax treatment are available. In summary, it is important that any new global plan design have a detailed due diligence review from a legal, tax and HR perspective before it is implemented. UNDERSTANDING THE IMPACT OF POSSIBLE CHANGE When the company has identified plan designs that meet its objectives, specific alternatives should be analyzed. Consideration should be given to the potential financial statement impact under FAS 123, as well as the effect on employee relations, retention and early retirement. Reaction from shareholders, analysts and the media should also be assessed. Human resource and financial managers should work together to help assure that goals in both areas are met. HR Insight 02/19 August 20, 2002 7
IMPLEMENTING AND COMMUNICATING PLAN CHANGES After reviewing possible plan design changes, the compensation committee of the board of directors must decide on a plan of action. In most cases, stock-based plans require shareholder approval, so development of the proxy will be a mandatory first step. At the same time, companies should effectively communicate changes to employees. New election forms, brochures, or letters describing changes and their impact on plan participants must be developed and distributed. Presenting the changes in a positive light is important, especially if the company decides to reduce stock-based programs to avoid financial statement charges. Although written communications are effective, many companies have found less formal ways, such as employee meetings, to explain plan design changes, answer questions and address concerns. HOW PRICEWATERHOUSECOOPERS CAN HELP PwC is uniquely qualified to address the broad spectrum of business, accounting, tax and human resource issues related to stock-based plans. We have been dealing with the complex issues related to FAS 123 since our 1993 study, Stock Options: Accounting, Valuation and Management Issues. Our experience and insight gained from with FAS 123 pro forma disclosures puts us on the leading edge in providing companies with accounting, compensation consulting, tax and valuation modeling assistance with respect to their stock-based plans. We are now helping numerous companies assess the impact of adopting FAS 123 from all points of view -- accounting, tax, regulatory, and strategic. The impact will vary widely from company to company and it is difficult to make generalizations about the effect of the change on a company s financial statements. PwC can assist companies in selecting valuation assumptions and models to measure expense under FAS 123. We can also help you consider any potential changes to your stock programs executive and broad-based. If you have any questions on accounting for stockbased plans, valuation techniques, FASB developments, plan design or any of the complex issues covered in this HR Insight or if you would like help in assessing the impact of adopting FAS 123 on your company, contact the PwC partner servicing your company or a local partner from the following list. For more information on the topic discussed in this issue or address change, contact your local PricewaterhouseCoopers professional. Atlanta, GA Ann O Connell Boston, MA Ed Donovan Chicago, IL Lou Joseph Cleveland, OH Dave Sunderhaft Columbus, OH Jeffrey Luedke Dallas, TX Duncan Harwood Detroit, MI Theresa Gee Houston, TX Duncan Harwood 678-419-2820 617-478-3722 312-298-2083 216-875-3052 614-225-8820 214-754-7244 313-394-3947 214-754-7244 Los Angeles, CA Ed Kimura McLean, VA Joe Walshe New Yor/Metro Steve Heindel Philadelphia, PA Ted Volz Pittsburgh, PA - Chris King San Francisco, CA Luan Fox Syracuse, NY Vince Spina Washington, DC Dave Dawson 213-356-6185 703-918-3238 646-394-1885 267-330-3180 412-355-6044 415-498-5444 315-473-1327 202-414-1014 PricewaterhouseCoopers LLP All Rights Reserved. HR Insight 02/19 August 20, 2002 8