The Financial Accounting Foundation, or FAF, has announced that they are going to conduct a post-implementation review of FAS 123(R). In today’s blog, I take a look at what this might mean for the future of stock plan accounting.
What the Heck?
The FAF oversees and provides funding for the FASB, as well as several other entities involved in promulgating US accounting standards. The FAF has recently begun conducting post-implementation reviews to evaluate the effectiveness of standards issued by the FASB (and also standards issued by GASB, Governmental Accounting Standards Board, which is the only other accounting standards board here in the United States–they aren’t just targeting the FASB).
You Can Take Your Aluminum Hat Off–They’re Probably Not Out to Get Us
Upon reading that the FAF is planning a post-implementation review of FAS 123(R), my first reaction was alarm. In the past, when various accounting authorities have reviewed US accounting standards on stock compensation, the outcomes haven’t been particularly favorable for those of us on team stock awards (notable examples include FIN 44, EITF 96-18, and, of course, FAS 123(R)). The FAF says (on its website) that standards are selected for a PIR based on “considerable amount of stakeholder input indicating that the standard might not be meeting its stated objectives.”
So I asked Bill Dunn at PwC about it and he put me in touch with his colleagues Ken Stoler and Pat Durbin (Pat is PwC’s national practice leader on standard setting). Ken and Pat don’t think the PIR signals any significant changes for stock plan accounting. They think that FAS 123(R) was selected for review merely because it is complex, pervasive, and has raised numerous practice issues–not because the FAF thinks there is anything wrong with the standard. They suspect that any changes that the FAF recommends will be minor and only in areas where divergence in practice has developed.
What Is a PIR?
According to the FAF website, the PIR has three main goals: to determine if the standard meets its stated objectives, to evaluate the standard’s implementation and compliance costs and benefits, and to provide feedback to improve the standard setting process. The PIR team uses a variety of procedures, including reviewing the project archives, reviewing academic and other research, and collecting stakeholder input via surveys and interviews. They then present their findings to the FASB’s chair and oversight committee.
As I understand it, the PIR team doesn’t recommend any specific standard-setting actions, they simply point out areas of concern and it is up to the FASB to decide whether or not to take action. Which means that this is a loonnnng process. First the FAF has to conclude the PIR, which takes a long time, and then the FASB has to act on their concerns, which takes even longer. But, the silver lining for me is that it sounds like there could be fodder for several blog entries along the way, especially if the FAF finds any areas of concern (which surely they will–it’s a big standard).
Why “FAS 123(R)”?
My other thought upon reading this was to wonder why the FAF calls the standard “FAS 123(R)” when the rest of us have to call it “ASC 718.” Because, frankly, it’s been a struggle to get used to the ASC 718 moniker. If the FAF can call it FAS 123(R), I thought maybe the rest of us could too. But, unfortunately, Ken doesn’t think we’ll all go back to calling it FAS 123(R) anytime soon.
One of the most common types of “unplanned” modifications I see in my consulting work, which we will cover in our presentation, is that of vesting modifications.
The text of the ASC 718 standard says this about modification accounting: Modifications of Awards of Equity Instruments
51. A modification of the terms or conditions of an equity award shall be treated as an exchange of the original award for a new award. …In substance, the entity repurchases the original instrument by issuing a new instrument of equal or greater value, incurring additional compensation cost for any incremental value. The effects of a modification shall be measured as follows:
a. Incremental compensation cost shall be measured as the excess, if any, of the fair value of the modified award determined in accordance with the provisions of this Statement over the fair value of the original award immediately before its terms are modified, measured based on the share price and other pertinent factors at that date. … b. Total recognized compensation cost for an equity award shall at least equal the fair value of the award at the grant date unless at the date of the modification the performance or service conditions of the original award are not expected to be satisfied. Thus, the total compensation cost measured at the date of a modification shall be (1) the portion of the grant-date fair value of the original award for which the requisite service is expected to be rendered (or has already been rendered) at that date plus (2) the incremental cost resulting from the modification.
But then the examples in ASC 718-20-55-111 through ASC 718-20-55-118 go on to delineate four, count them four, different types of vesting modifications, with two different treatments:
Type I: Probable to Probable: Recognize fair value of original award + incremental expense, if any.
Type II: Probable to Improbable: Recognize fair value of original award + incremental expense, if any.
Type III: Improbable to Probable: New fair value only. Reverse expense for any unvested shares.
Type IV: Improbable to Improbable: New fair value only. Reverse expense for any unvested shares.
Type II and Type IV are incredibly uncommon, but we DO see a good number of Type I and Type III. Type I are often triggered by option exchanges, or any modification to already vested shares, like an extension of exercise grace period at termination. Type III modifications are also quite common at the time of termination when unvested shares are accelerated.
How do you handle the modifications? First, decide if they are Type I or Type III. If the shares are vested, chances are good you are dealing with a Type I. If the shares would have been cancelled if not for the termination, then chances are good you have a Type III. If a Type I, perform two fair value calculations: one before the change, and one after, and compare the expense to determine your incremental expense. If a Type III, you need only one fair value calculation, using the attributes of the grant after the modification. Calculate how much expense has already been booked for the unvested shares in the grant and true up (or down) to the new fair value.
There is good news about most modifications, especially those at the time of termination: they are generally fairly simple one-time calculations where all the expense is booked immediately. Once and done. The bad news is that most systems have limited support for modification accounting and the inputs can be quite tricky. What is the expected term of an underwater option before it is exchanged for a new option? Is it the remaining expected term from the original grant date fair value? The remaining contractual life? An expected term calculated by a Monte Carlo simulation? Each company must decide for itself. A few examples in the standard seem to point to remaining contractual term, but the Monte Carlo simulation approach seems to fly past audit as well. No two audit firms, or audit partners, seem to have the same opinions.
Join me and my talented co-panelists in New Orleans as we wrestle modification accounting to the ground and give you a solid understanding of the required treatment and some varying interpretations. Laissez Les Bon Temps Roulez!
Last week, I compared Apple and Google’s stock compensation expenses and determined that Google’s expense is significantly higher because Google’s grants have historically been for greater amounts of fair value. This week I look at the underlying question of why Google is granting more value (and, thus, presumably more compensation) to its employees.
Apple and Google: The Real Question All other things being equal, both companies are competing for the same talent pool, in the same area of the country, and should presumably be granting about the same amount of fair value. In fact, because Google has about half as many employees as Apple, you might expect Google to be granting awards for about half as much aggregate fair value as Apple, not almost twice as much fair value, as has been the case in some years.
Mitigating Circumstances
Of course, it’s not that simple. I’m sure part of the problem is perceived value. From a fair value standpoint, the higher the stock price, the more value an option has (both companies grant a combination of options and stock). But employee’s tend to assign a lower value to options with a higher exercise price. So while Google’s skyrocketing stock price (averaging about 2.4 times higher than Apple’s over the four years of grants that I compared) has also caused their stock plan expense to skyrocket, that hasn’t translated into higher perceived value for employees. In fact, the reverse is true. So Google has likely had to grant a disproportionately high number of shares for its employees to assign the same value to their option grants as Apple’s employees do. This is one of the inefficiencies of stock options.
Another consideration may be other compensation programs that each company offers. A response to the blog I referenced last week noted that Apple has an ESPP but Google doesn’t. (Wait–what? Google doesn’t have an ESPP? How in the heck can that be? It’s true though, their 10-K makes no mention of an ESPP.) Because Apple has an ESPP, which, in my opinion, has a high perceived value in comparison to fair value (especially in Silicon Valley), they may be able to make smaller awards to employees. Apple’s ESPP increases its stock plan expense, however, so this clearly isn’t the whole story. But Apple may offer other benefits–bigger cash bonuses, work-life programs, etc.– that aren’t included in their stock plan expense and that offset the smaller awards to employees.
And, although we think of these companies as being located in Silicon Valley, they are both large organizations with offices and employees in many locations. Apple, for example, has main campuses in Austin, Singapore, and Ireland, in addition to Silicon Valley. Having offices outside of the valley may impact Apple’s compensation structure.
The Real Reason
Finally, however, I suspect that the real reason Google is recognizing more expense for their stock plan can be found in the Beneficial Ownership of Management Table in the proxy statements of the two companies. As a group, Apple’s executives and directors control less than 1% of Apple’s outstanding common stock. Google’s executives and directors as a group control 69% of the votes on Google’s stock. In fact, the two founders together control close to 58% of the votes.
The amount of votes that Google management controls means that Google gets to do things with its stock plan that Apple’s shareholders probably won’t stand for, including offer a one-for-one option exchange and grant awards for greater value year after year. Google doesn’t care about burn rates and overhang: they aren’t worried about getting approval for their next allocation of shares to their plan (or their Say-on-Pay proposal)–they already have the votes they need.
Paid Out?
It’s interesting to me that the blogger characterized the stock plan expense as amounts that were “paid out”: “On last week’s Google (GOOG) earnings call, CFO, Patrick Pichette revealed that Google paid out [emphasis added] $384 million in stock-based compensation in the June quarter.” He makes a similar statement regarding Apple.
I didn’t listen to the earnings calls, but I’d be surprised if the companies characterized this as a pay-out. When I first read the blog, I thought maybe he was referring to the intrinsic value realized upon exercise of options, and not stock compensation expense, but Google employees only realized $86 million in intrinsic value on their option exercises (and an undisclosed amount, but less than $4 million, on sales of options in Google’s TSO program), so this isn’t the case.
I suspect this is a common misperception in the media and I wonder if the blogger understands that the expense Google and Apple recognized has no relation whatsoever to the amounts employees are actually realizing on their stock compensation.
NASPP Conference Hotel is Filling Up Don’t wait any longer to make your hotel reservations for the 19th Annual NASPP Conference–the Conference hotel is quickly filling up. The Conference will be held from November 1-4 in San Francisco; register today and make your hotel reservations before it’s too late!
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Don’t miss your local NASPP chapter meetings in Michigan, Phoenix, and San Diego. Robyn Shutak, the NASPP’s Education Director, will be at the San Diego meeting and both Robyn and I will be at the Phoenix meeting. We hope to see you there!
Indecent Disclosures: Polishing and Perfecting Disclosures under ASC 718 By Elizabeth Dodge, Stock & Option Solutions
Disclosures under ASC 718 are a dreaded topic for nearly all my clients. The standard is unclear in some areas and flouts common sense in others, so what is a company to do? The answer? Do your best and try not to sweat the small stuff, unless your auditors force you to do so. In this entry, I’ll review one confusing part of the standard relating to disclosures and suggest ‘the right’ approach to take.
What Are “Shares of Nonvested Stock”?
In FAS 123(R), pre-codification, paragraph 240(b)(2) required the disclosure of:
The number and weighted-average grant date fair value…of equity instruments not specified in paragraph A240(b)(1) (for example, shares of nonvested stock), for each of the following groups of equity instruments: (a) those nonvested at the beginning of the year, (b) those nonvested at the end of the year, and those (c) granted, (d) vested, or (e) forfeited during the year. [emphasis added]
Paragraph 240(b)(1) asked for the number and weighted-average exercise price of options (or share units) outstanding. So what the standard seemed to require in the paragragh I quote above is the number and grant-date fair value for instruments other than options and share units, such as “shares of nonvested stock.” Clear as mud, so far? What is a share of nonvested stock, you ask? See footnote 11 on page 7 of the standard which reads:
Nonvested shares granted to employees usually are referred to as restricted shares, but this Statement reserves that term for fully vested and outstanding shares whose sale is contractually or governmentally prohibited for a specified period of time.
As if the standard wasn’t complicated enough, the FASB needed to define their own terms and use terms we thought we understood to refer to something else. Great idea. So a share of nonvested stock is therefore a restricted stock award (not a unit, but the kind of award on which you can file a Section 83(b) election). Here the FASB is lumping options and units (RSUs) together and separating out RSAs into a separate category. Perfectly logical, because RSUs are much more like options than RSAs, wouldn’t you agree? (And if you’re not getting the depth of my sarcasm, try re-reading the text above.)
Okay. So what do we use for weighted average exercise price for an RSU? Most RSUs that I’ve encountered don’t have an exercise price (and in fact, aren’t even exercised!). So obviously you should report zero here?
And most audit partners are unfamiliar with this issue all together. The good news is that most of them seem to ignore the actual language of the standard and, instead, require the same disclosures for RSUs and RSAs, which honestly does make a lot more sense, but isn’t what the standard calls for.
Unfortunately many systems/software providers were reading the standard carefully when they designed their disclosure reports, so often the RSU disclosures have “exercise price” but lack grant date fair value, so you’re often forced to calculate some of these numbers manually.
So now you’re thinking, but the Codification cleared all this confusion right up, didn’t it? Well, no… it did change the language just slightly. It removed “(for example, shares of nonvested stock).” It also added a link to the definition of “Share Units,” which reads: “A contract under which the holder has the right to convert each unit into a specified number of shares of the issuing entity.” Sounds like an RSU to me.
So where does all this leave us? My conclusion: Listen to your auditor, follow their guidance, which may not follow the standard to the letter, but makes more sense. Other folks are unlikely to notice the issue in the first place, but your auditors will.
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A few weeks ago, the following headline showed up in one of my Google alerts: “Why Did Google Pay Nearly Twice In Stock-Based Comp than Apple last Quarter?” I like to think of myself as being pretty smart about stock plan accounting, so this seemed like a question I ought to be able to answer. Today, I take it on.
Apple to Google: Stock-Based Compensation As noted in the story, both companies are Silicon Valley high-tech companies, competing for a lot of the same talent pool against a lot of the same companies, so you’d expect them to have similar compensation strategies. Digging a little further into their Forms 10-K, I was able to determine that they both grant a mix of stock options and RSUs. Apple has some RSUs that vest in as few as two years and Google has some RSUs that have some sort of cliff vesting that I couldn’t figure out from their disclosures, but other than those minor differences, their options and awards vest over four years. In addition, both companies recognize expense on a straight-line basis, so monthly versus annual vesting wouldn’t account for a difference in the expense they recognize. (Google has options that vest monthly; Apple’s options vest annually, bi-annually, or quarterly. Google appears to have at least some RSUs that vest annually, I couldn’t figure this out for Apple).
Apple’s stock plan expense for their quarter ending on June 25, 2011 was $284 million. Google’s stock plan expense for essentially the same quarter was $435 million.
Is it Google’s Exchange Program?
At first I thought maybe the difference was due to Google’s option exchange program. In March 2009, Google completed an option exchange program that was notable in that 1) it was a one-for-one exchange, which is virturally unheard of these days and 2) they allowed options that were barely underwater to be included in the exchange, rather than including only those options that had exercise prices in excess of their 52-week high. The incremental expense for a one-for-one exchange that included somewhere around 50% of their outstanding options seemed like a good candidate to explain the difference in expense.
But I don’t think this is it. The exchange resulted in a charge of $360 million, of which $189 million has already been recognized and the rest ($171 million) will be recognized over another three or so years. This could account for some of the difference, but I don’t think it is the whole story.
So What Is the Difference?
I think it just comes down to the fact that Google has been making grants for more value in the past few years than Apple. This is probably in part due to the fact that Apple’s average stock price for the past four years is around $210 per share and Google’s average stock price for this same period is around $510 per share. Where grants are based on a percentage of compensation or some other monetary amount, a higher stock price theoretically means that the company will grant options and awards for fewer shares. But, given differences in compensation philosophies between companies, I’m not sure that this will be true when comparing, say, Apple to Google.
In other words, if Apple’s stock price were to double from one year to the next, I would expect that the number of shares they grant might decrease commensurately. But just because Apple’s stock price is less than half Google’s price doesn’t necessarily mean that they are granting a commensurately greater number of shares than Google. There are just too many other factors at play in compensation decisions.
And, in fact, the total fair value of Google’s grants (both options and RSUs) for their 2010 fiscal year was somewhere around $2.4 billion, whereas the total fair value of Apple’s grants for the same period was somewhere around $1.3 billion. For their 2009 fiscal years, there is a similar discrepancy: $1.6 billion in fair value for Googe’s grants and .9 billion in fair value for Apple’s grants. Interestingly, for 2008, the companies granted about the same amount of fair value. but for the 2007 year, the aggregate fair value of Google’s grants was $1.8 billion to $.6 billion for Apple.
BTW: 1) Note that I am backing into the aggregate fair value per year numbers by multiplying the shares granted by the weighted average fair value for grants during the year. 2) Kudos to Apple for voluntarily including three years in their stock plan activity roll-forward, so that I didn’t have to pull up each 10-K separately to get their grant amounts for all three years.
With vesting schedules–and, consequently, service periods–of four years, both Google and Apple’s current expense includes the fair value of grants made in prior years, going all the way back to 2007. Because Google has historically issued awards with a greater aggregate fair value than Apple, they are now recognizing more expense for those awards (plus they have some additional cost as a result of the option exchange program).
Tune in Next Week
This perhaps explains the difference in the current period expense, but it doesn’t explain why Google is granting awards for significantly more fair value than Apple, especially given that as of their most recent Forms 10-K, Google has only 24,400 employee compared to Apple’s 46,600 employees. Tune in next week when I discuss this question.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
I’m going to start this discussion from the end and start with the company’s tax deduction. Certain employee stock compensation transactions that result in taxable income (e.g., non-qualified stock option exercises and restricted stock vests) are eligible for a corresponding company tax deduction. For example, if an employee realizes $1,000 income on an NQSO exercise and the company’s applicable tax rate is 40%, the company is eligible for a tax deduction of $400.
However, under FAS123(R), a company can’t just wait for the transaction to take place and then book the entire tax deduction. Instead, it must try and anticipate what that tax benefit will be and book it over the same schedule as the expense accrual for the award. Because the company can’t know for sure what income will result from eligible transactions, FAS123(R) details how to go about anticipating that unknown with as a deferred tax asset (DTA).
Calculating DTA
DTA, unlike the actual tax deduction, is calculated based on the FAS123(R) valuation of the grant using the company’s current tax rate and is generally booked over the vesting schedule. For example, if the company is expensing $5,000 for an NQSO each year over a four-year vesting schedule and the company’s tax rate is 40%, the company books a DTA of $2,000 each year of the same schedule (adjusted for expected forfeitures until the actual vest date).
Back to the End
When a transaction does take place the company can calculate the actual tax deduction, which will most likely be either more or less than the DTA amount. The company reverses the DTA that was previously booked and takes the actual tax deduction. However, the difference between these two numbers must also be reconciled. If the DTA is less than the actual tax deduction (i.e., the company realized more than the anticipated tax benefit), the company adds the excess tax benefit to the paid in capital account–often referred to as the APIC pool. However, if the actual tax deduction turns out to be less than the booked DTA (i.e., the company anticipated more tax benefit than it realized), then the company reduces the existing APIC pool by the unrealized tax benefit amount–or takes a tax expense if the APIC pool isn’t sufficient.
Get More
This is, of course, just the beginning of tax accounting for equity compensation under FAS123(R)–or even just a full conversation on deferred tax assets. We have a wealth of information on the NASPP’s Stock Plan Expensing portal. We also have an in-depth webcast in the NASPP webcast archive, “Practical Guide to Tax Accounting Under FAS 123(R).” However, if you are looking for the total information package on financial reporting, including accounting for tax effects, I highly recommend the NASPP’s course, Financial Reporting for Equity Compensation. The first class is today at 12:00 PM PT, but if you miss it, don’t worry. Not only are there four more fact-filled sessions, you can catch up on the recording of today’s class and take advantage of all the bonus materials. Register now!
Volatility is one of the inputs used to calculate a Black-Scholes model valuation of stock options. As volatility increases, so does the maximum gain that an employee could realize through a future exercise of their option. This, in turn, increases the value of that option, which may be a difficult concept to reconcile when the volatility is increased because of a down market!
With the recent turmoil in the stock markets, companies may find that the volatility they are using to value their stock options is jumping up as their stock price drops. Whether companies are using implied volatility or their own historical volatility, the recent changes in stock price could have impacted those numbers dramatically. There was a thread on this in our NASPP Discussion Forum recently on how to handle these changes, and I’m sure the question on many peoples’ minds right now is “should my company be doing something to deal with this increase in volatility?”
Companies may have created their method of calculating the volatility assumption without anticipating such a sharp downturn in the market. Now, they are looking at their method to see if it is still the best approach. The real intent of calculating volatility is to provide the best estimation of what future volatility will be. Ideally, the period of time the company is using to analyze historical or implied volatility will be long enough to provide an appropriate amount of stability which will accommodate short-term fluctuations. The shorter the period of time being analyzed, the more impact short-term fluctuations have, which may not be a reasonable reflection of what the company’s stock price volatility will look like over the life of the option. On the other hand, won’t options granted during this economic downturn have a higher chance of realizing gain through a dramatic increase in stock price over the life of the grant?
If this is the beginning of the fiscal year for your company, then it is a good time to take a look at how you are coming up with your valuation assumption. This is your opportunity to review your process for estimating volatility to see if it really is the most appropriate. Keep in mind, however, that FAS 123(R) clearly states that the method for determining the estimates should not only be “reasonable and supportable” (Paragraph 16), but also be “determined in a consistent manner from period to period” (Paragraph 23). So, if you are considering a change, such as an increase in length of time included in the calculation or a change to the way you weigh different periods, you will need to make sure that it is a change your company can not only justify to your auditors now, but also sustain as a valid method going forward.