Share Based Compensation

Different types of employee compensation include:

Short term (less than 12 months): Salaries, wages, bonus, health insurance, company match in defined contribution plans, and paid leave.

Long term (greater than 12 months): Long term disability and long term paid leave. Stock based: Options or stock grants. Post retirement: Defined benefit pensions and health care.

Employees earn their compensation at the end of a vesting period. This is typically a couple of weeks for salaries or wages, but several years for stock and option grants. At the end of the vesting period, the compensation is settled (either by payment in cash or by issuance of stock) on the settlement date.

Short term compensation is expensed to the income statement as it vests; any amount unpaid at the end of the year is shown as a current liability. Compensation expense is not separately disclosed; rather, it is embedded in appropriate expense categories. Wages for factory workers are included as part of cost of goods sold.

Any compensation expense associated with unsold inventory is capitalized (i.e., included in the value of ending inventory on the balance sheet). Compensation expense for employees engaged in research is included in R&D expense.

Share based compensation plans (which are typically offered to managers) can take several forms, including stock options and outright share grants. Share based compensation can motivate and retain key employees, and serve as a way to reward employees with no additional outlay of cash by the firm. There are drawbacks though.

For example, the additional stock dilutes the interests of shareholders. Also, because most employees’ actions have a minimal impact on the stock price, the motivational value that these grants provide may be limited. Furthermore, the asymmetric (i.e., upside only) payoff of stock options may incentivize managers to take too much risk.

Stock grants, on the other hand, may excessively tie managers’ personal wealth to that of the company (along with their existing employment) and, therefore, may motivate those managers to take a less than optimal amount of risk.

Stock Options

Employees are granted nontradeable call options. If the stock price is greater than the exercise price (i.e., the option is in the money) when the option vests (but prior to the maturity of the option), then the employee can exercise the option and earn the difference. Compensation expense is based on the fair value of the options on the grant date.

The compensation expense is then allocated straight line (i.e., amortized in equal installments) to the income statement over the vesting period, which is the time between the grant date and the vesting date. This compensation expense will decrease net income and retained earnings, and the offsetting entry is to increase the share based compensation reserve (which is part of equity). Because the share based compensation reserve increases by the same amount that retained earnings decreases, there is no change to total equity.

Determining Fair Value

The fair value of a stock option is determined based on the observable market price of a similar option, if a comparable option is available. Otherwise, the firm can use an option pricing model such as Black Scholes. Neither IFRS nor U.S. GAAP mandates a particular valuation model; however, the model used should be consistent with sound economic principles, consistent with fair value measurement requirements, and reflect all substantive elements of the grant.

Note that fair value is only estimated on the grant date; subsequent changes in fair value are not considered.

Companies are required to disclose the assumptions used to estimate fair value. While most of the assumptions (e.g., grant date, stock price, maturity, exercise price, and the risk free rate) are observable, assumptions about future stock price volatility are subjective. Companies often use implied volatilities based on other market traded options on the company’s stock or based on historical volatility.

If a lower estimate of future volatility is used, the value of the options will be underestimated; hence, the compensation expense will be underestimated, and reported earnings will be higher.

Employees will exercise options only when they are in the money and those employees that leave before the options vest forfeit their grant.

Conditional Grants and Stock Grants

Stock or option grants often have specific conditions attached for the grants to vest. Restricted stock grants have requirements that must be met before the stock can be sold. A service condition is the most common restriction; this simply specifies the number of years of employment required before the options or stock vest.

Under a performance condition, the grant vests upon achievement of a specific target (e.g., the EPS exceeds some amount) or a market condition where the target is based on a market metric (e.g., stock price). Performance based restricted stocks are called performance shares. Restricted stock units (RSUs) are similar to performance shares, but instead of receiving shares upfront, RSUs are exchanged for stock when they vest.

(Note that employees receiving RSU don’t accrue any dividends during the vesting period). RSUs are preferred over stock options by employees because they accrue some value if the stock price is above zero, are simpler for individual tax calculations, and have no exercise price outlays.

The value of a stock grant is simply the value of the stock on the grant date times the number of shares granted. For RSU, the stock price is reduced by the estimated present value of dividends expected during the vesting period. The total value is expensed over the vesting period and taken to equity as part of share based compensation reserve.

Upon settlement, the value of the stock is transferred out of the share based compensation reserve and allocated to common stock and paid in capital. For option grants, upon exercise, there is a cash inflow from the strike price that is reported as financing activity in the cash flow statement. This exercise amount, along with the amount in the compensation expense reserve account, is allocated to common stock/paid in capital.

If the options expire out of the money, there is no further accounting treatment.

Tax Implications

For financial reporting, the compensation expense is based on the stock price on the grant date (for both option and stock grants). However, for tax purposes, deduction for stock based compensation is only allowed upon settlement.

Tax deduction for stock grants

Tax deduction for options

If the stock price on the settlement date is higher than the grant date price, the tax deduction will be higher than the cumulative compensation expense reported, resulting in a tax windfall or excess tax benefit. On the other hand, if the stock price on the settlement date is lower than the grant date price, there will be a tax shortfall.

Tax windfalls and shortfalls are reported directly to equity under IFRS. Under U.S. GAAP, tax windfalls (shortfalls) reduce (increase) tax expense in the income statement. The income statement treatment of tax windfalls and shortfalls results in volatility in the reported net income and in the effective tax rate.

Dilution Effects

Upon settlement, stock and option grants (if exercised) increase the number of basic shares outstanding. Prior to settlement, these grants can be potentially dilutive. (Recall from Level I, dilutive securities are those that reduce the fully diluted EPS.) If the shares are dilutive, they should be included in diluted shares outstanding using the treasury stock method.

If a company reports a net loss, basic EPS and fully diluted EPS will be the same (i.e., dilutive securities = 0).

The determination of whether performance shares are potentially dilutive can be subjective.

Performance shares that vest based on a period of service are usually considered dilutive if the stock price has not declined substantially. However, expectations about vesting of shares based on other performance metrics (such as an increase in EPS over the vesting period) is more subjective.

Unvested options that are in the money are considered dilutive. RSUs and restricted stock grants are considered antidilutive only if the current stock price is significantly less than the price on the grant date (i.e., when the unrecognized compensation expense per share is higher than the current market price).

The treasury stock method nets the number of hypothetically repurchased shares against the total number of potentially dilutive securities. The number of hypothetically repurchased shares is based on the average share price during the reporting period.

Expense for share based compensation is not separately reported in the income statement; rather, it is included in COGS (for manufacturing employees), R&D expense (for research employees), and SG&A (for management). If we expect the relationship between each of these expense categories and revenues to remain static, then we need not separate out share based compensation for forecasting purposes. However, if those proportions do not hold, we should first subtract the amounts attributable to share based compensation from each of the relevant categories, then forecast individual expenses as a proportion of revenues (based on historical trends), and finally forecast the share based compensation separately.

Information sources that may help predict changes in share based compensation include historical data, management guidance, and assumptions about reversion to industry mean.

Another benefit of separating share based compensation is its treatment in the cash flow statement. In the forecast statement of cash flow, share based compensation should be added back to net income to arrive at cash flow from operating activities. The expected cash inflow from the exercise of options should be reflected in financing activities.

An analyst should additionally forecast the increase in the number of shares outstanding (i.e., the dilution effect). Unvested grants can be accounted for by using the diluted number of shares outstanding as reported. A more conservative analyst will add the gross number of antidilutive shares (rather than using the treasury stock method).

Estimates of future grants are more challenging to forecast. The dilution from future grants can be estimated by discounting the estimated value of equity by a dilution factor or by estimating an increase in the number of shares outstanding.

Because share based compensation is noncash, a company with a higher noncash compensation component will report higher free cash flow (and any other cash flow measure). Ratios such as P/FCF are often used in relative valuation to compare a company to its peers. Such a comparable analysis would be misleading when there are significant differences in the compensation structure (cash compensation vs. share based compensation) across the companies.