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  March 2006   

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What should companies do in response to Statement 123(R)?

The issuance of Statement 123(R) is leading some companies to reconsider the design of their equity-based employee plans. This section provides our advice on some points to keep in mind.

  1. Assess the impact on your company
    The proposed changes in accounting will affect companies differently depending on a wide range of factors such as, the current use of employee stock plans, the stage of development, risk profile, and need for entrepreneurial talent. Companies need a clear understanding of these factors, along with their objectives, so they can respond appropriately to the effects of the accounting changes on their particular facts and circumstances. Companies that have not already done so should take steps now to assess the impact of the accounting changes and consider what actions, if any, should be taken to mitigate that impact.

    In making that assessment, companies should not overreact to the changes. A compensation charge for stock options is unlikely to have the adverse effects feared by the FASB's strongest critics. Pro forma earnings and earnings per share on a fair value basis have been disclosed for 10 years. Shareholders, analysts, creditors, and others already know in general terms the impact that Statement 123(R) will have on reported earnings. Those companies that voluntarily adopted the fair value method over the past two years experienced no discernable impact on their share prices. Furthermore, because most companies will be adopting the final Statement at about the same time, no company will be at a disadvantage relative to its peers.

  2. Consider alternative compensation strategies
    It is appropriate to take a fresh look at compensation strategies in light of the new accounting guidance, but decisions should be driven primarily by what strategies provide the best incentives for employee performance and best align the interests of employees and shareholders. Accounting and income tax objectives, while important, should be subordinate to sound compensation objectives.

    Under Opinion 25, zero compensation is recorded for options with a fixed exercise price equal to market price at date of grant and no performance conditions. Many companies like that accounting result, which has helped to make such options the most common form of equity-based employee award. However, Opinion 25 also acts as a straightjacket, because modifications to make options more effective incentives usually result in variable accounting and exposure to uncontrollable compensation charges if the stock price increases. Thus, Opinion 25 deters innovations in option design. Under Statement 123(R), compensation is measured at grant date for a broader variety of equity awards, creating a more level playing field for different option features, for example, performance conditions and exercise prices that are higher than the market price at date of grant.

    Under Opinion 25, any performance condition other than employee service delays the measurement of compensation until the outcome of the condition is known. This feature effectively deters most companies from including these performance conditions. The only type of performance incentive that is at all widespread under Opinion 25 is the time-accelerated option or restricted share. Under these arrangements, vesting is accelerated if the performance condition is achieved, but the award will vest based solely on employment (for example, at the end of 10 years) if the performance condition is not achieved. Because the time-based vesting undermines the incentive effect of the performance condition, time accelerated plans likely would not exist were it not for Opinion 25. Statement 123(R) permits companies to measure compensation at grant date for awards with performance conditions.

    One of the criticisms of traditional options is that they can reward mediocre performance. If a company grants its CEO a 10-year option on 100,000 shares of stock with an exercise price of $10 per share (market price on date of grant), and its stock price appreciates at 4% per year for 10 years, the CEO has a profit of about $480,000 at the end of 10 years. Given that the shareholders could have earned more than 4% per year in U.S. Treasury bonds, some critics believe that is an excessive reward. Compensation consultants have developed a number of proposals to mitigate this deficiency of traditional options. Here are several of those ideas and a summary of how they affect the accounting under Opinion 25 and Statement 123(R).

    • Performance-based vesting. Exercise of the options is conditioned on meeting specific company performance criteria, such as market share growth, growth in income from continuing operations or earnings per share, or some other measure. Under Opinion 25, the number of shares is not fixed, so measurement of compensation is delayed until the performance conditions are met (variable accounting). Under Statement 123(R), the fair value of the options would be estimated at the grant date, and only the number that vest would vary.
    • Premium price options. Grant options with an exercise price of $15 per share, a 50% premium over the current stock price. If the share price does not appreciate by at least 50% (thereby outperforming U.S. Treasuries), the CEO has no profit on his options. Under Opinion 25, this option also has zero compensation. Although it is more favorable to the shareholders and less generous to the CEO, the compensation expense is identical to the traditional option. Under Statement 123(R), a $15 option would have lower fair value and lower compensation expense than a $10 option.
    • Indexed price options. Grant options with an exercise price of $10 per share that increases each year. If the share price does not outperform U.S. Treasuries, the CEO has no profit on his options. (The option price also could be indexed to a stock market index or to the rate of return on peer companies' shares.) Under Opinion 25, the exercise price is not fixed, so the measurement of compensation is delayed until exercise date. Under Statement 123(R), an option with an indexed exercise price would be measured at grant date and would have lower fair value and lower compensation expense than a fixed $10 option.
    • Stock price hurdle. Grant options with an exercise price of $10 per share that only can be exercised if the company's share price exceeds $15 per share for 30 consecutive trading days. If the share price does not appreciate by at least 50%, the CEO cannot exercise, and cannot profit from his options. Under Opinion 25, there is an uncertainty about the CEO's right to buy the shares for a reason other than his service. As a result, the measurement of compensation is delayed until the stock price hurdle is satisfied, resulting in compensation expense of at least $500,000 it the option does become exercisable. (The compensation expense could be higher if the share price is higher than $15 on the 30th trading day.) Under Statement 123(R), an option with stock price hurdle would be measured at grant date and would have lower fair value and lower compensation expense than a fixed $10 option.

    Other changes to consider may include switching from option grants to grants of restricted stock, an action taken by Microsoft and others. Alternatively, in addition to some strategies mentioned above to reduce compensation expense, companies may want to shorten terms or exercise periods. Additionally, incorporating cashless exercise features, particularly net settlement arrangements, are attractive as they are treated as equity awards under Statement 123(R).

    In light of the more narrow rules under Statement 123(R) defining noncompensatory plans, changes to broad-based employee stock purchase plans would include reducing current discounts offered from the more common 15% to the benchmark 5% "safe harbor" and also eliminating significant option features such as lookback features in order to qualify for noncompensatory treatment.

    These are just a few of the many creative ideas compensation consultants have developed for better aligning the interests of employees and shareholders. Variable accounting under Opinion 25 acts as a significant deterrent to implementing these ideas. In light of Statement 123(R), companies may wish to consider changing their plans to take advantage of the expanded ability to measure compensation at grant date.

  3. Explain any changes in compensation strategy to investors
    In response to criticisms of perceived excessive option grants in the late 1990s, some companies have switched to restricted stock awards, and some investors may erroneously conclude that this strategy is preferable for all companies. We still remember that 15 years ago critics called restricted stock "pay for pulse" and said that large restricted stock grants were a sign that management was pessimistic about the company's stock price. At that time, critics touted options as the performance incentive alternative to restricted stock. Now options are falling out of favor, and restricted stock is back in vogue. Some companies are addressing the past criticisms of restricted stock by adding performance conditions.

    The key mission for boards of directors is to select the key goals that management and employees should strive to achieve, and then craft equity plans that attract and retain qualified personnel, spur achievement of those goals, and align the interests of employees with shareholders. The establishment and communication of those goals and the tailoring of equity awards to those goals are key. Absent thoughtful goals and linkage of the awards to the goals, neither restricted stock nor options are a panacea. This sentiment is supported and reiterated by the SEC staff in SAB 107.


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Copyright © 2006, BDO USA,LLP. Material discussed in this Financial Reporting newsletter is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual facts and circumstances.