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Stock Compensation Plan Management & Expensing | April 2007
Expensing of stock-based compensation is now mandatory on an international basis and is of concern to any compensation plan administrator. The following reviews the dates after which the expense of any compensation plan must be formally disclosed in the financial statement of the sponsoring corporation.
- Canada – fiscal years beginning on or after Jan 1, 2004 (CICA 3870)
- US – fiscal years beginning on or after Jun 15, 2005 (FAS 123(R))
- International - fiscal years beginning on or after Jan 1, 2005 (IFRS2)
Historically the expense of stock-based compensation has been recognized only in passing as a footnote in the corporation’s financial statements and within the diluted earnings per share (EPS) calculation. The new rulings seek to provide a more transparent disclosure of the value (and cost) associated with stock-based compensation by requiring the expense to directly impact the income statement.
The issue of stock based awards has an associated value for both employers and employees in the form of additional non-cash based compensation. The employee receives the award in conjunction with salary and is likely in lieu of additional cash compensation. The employer is able to provide this award without the burden of additional salary costs. It is this value that the expensing of stock-based compensation tries to recognize. This is spotlighted in the historical cases of individual executives accepting large stock-based compensation awards which were not necessarily an alternative to adequate cash based compensation.
Expense Calculation (Valuation Models)
The expense of stock-based compensation is based on associating a fair value with the award at the time of grant. The fair value for an award can be determined using a market based approach, or through the use of a valuation model such as Black-Scholes or an instance of a lattice model. The primary exception to this is the case of basic share unit awards in which the intrinsic value of the award at grant date also passes as the fair value of the award.
As the majority of corporations do not have publicly traded options which have the same or similar terms and conditions as the issued stock-based compensation awards, a market based approach is not appropriate and a valuation model must be used. The valuation model is mathematical model or formula used to create a forecast value for the award based on inputs regarding past share price, grant price of the award, current interest rates and expected life of the award.
The following is a breakdown of the inputs required to use the Black-Scholes model to calculate the fair vale for an award.
Grant Price
The exercise or strike price attached to the award of the grant.
Market Price
The market price of the underlying security at the time of grant.
Expected Volatility
The projected magnitude of change in price of the underlying security on an annual basis.
Risk Free Rate
The interested rate that can be obtained by an investment with a zero risk of default. e.g..
US or Canadian issued government bonds.
Expected Dividend Yield
The dividend yield or rate as determined by the corporation for the underlying security.
Expected Life
An estimate of when the employee will exercise, generally the average lifetime of the
option/awards between grant an exercise.
The trinomial lattice models provide the ability to supply further criteria to determine the expected life of the award. The following describes the additional criteria required for the Hull-White model and which replaced the expected life input.
Time to Vest
The time period between grant date and vest date.
Time to Expiry
The time period between grant date and expiry date.
Suboptimal Exercise Factor
The multiple of the original grant price at which it assumed an employee will exercise
regardless of time to expiry.
Annual Employee Exit Rate
The likelihood or probability that an employee will leave or be terminated prior to vesting
of the award(s).
Expense Reporting
When the appropriate model has been selected and the criteria (parameters) for the model have been determined, the fair value for the award can then be calculated. The corporation has the option to determine this fair value at an grant level or for each individual vesting tranche. This fair value is synonymous with the expense for the award which must then be amortized over the requisite service period as determined by the vesting criteria. The expense may be amortized on a straight-line (equal) basis over the vesting period. Alternatively the expense for the award may be amortized on a graded basis, meaning that that the expense for each vesting tranche is amortized separately causing the cumulative expense to be front loaded.
With these final criteria the corporation may then determine an individual fair value (expense) for each tranche (or tranche) and the period over which that expense will be amortized. The summation of the fair value for all awards over the period to be amortized gives the total expense for the corporation and will be booked for that period. The actual expense for an individual period may differ from the original estimate due to varying forfeiture rates. The expense for any award cancelled prior to vest is cancelled and the expense reversed. As the number of awards that may be cancelled is only an estimate the actual forfeitures will likely differ.
A final factor to consider is the effect of retirement eligibility on the requisite service period. In the event that a plan states that awards continue vesting or vest immediately upon retirement then the awards are deemed to have vested immediately upon an individual reaching the required age for retirement eligibility. This accelerates the amortization of the expense for any awards granted to an individual reaching retirement eligibility.
