Welcome back. In this lesson,
we're going to switch gears a little bit.
Instead of talking about stock options,
we'll be talking about something called Stock Appreciation Rights.
So, what is a Stock Appreciation Right?
Well, a SAR, S-A-R,
is a type of compensation plan that gives an employee the right to receive an amount
calculated as the increase in value of
a predetermined number of shares of stock over a specified time.
So what it does is,
without actually getting the stock,
or owning the stock,
you get the appreciation in the stock order to,
that's why it's a stock appreciation right.
And of course, there's no penalty if the stock value goes down.
So, it's similar in
its incentive impact but it doesn't involve the actual issue of shares.
So the stock appreciation rights, again,
can be cash-settled, or they can be stock-settled.
And how they're settled makes a difference in the accounting.
A cash-settled SAR pays out the appreciation in the form of cash.
A stock-settled SAR pays out the appreciation in the form of stock.
Now, it's not stock option where you
pay the strike price and get a certain number of shares.
It's the appreciation on that number of shares,
which is the award,
is then paid out in the form of stock,
and the employee can either elect to keep those or sell it for cash.
So an important feature of SARs is that when the SARs are settled by issuing shares,
it can be classified as equity.
And by now, you should realize that classifying an award as equity
is very advantageous in terms of the amount of expense.
It's recognized as opposed to measuring the award as a liability.
When the SARs are,
or could be, cash settled though,
the awards are going to be classified as a liability and that accounting is going to be
very similar to the fair value through net income model that's used,
for example, for debt instruments,
or for trading securities.
So, let's look at an example of a cash-settled SARs.
Auto Chauffer sets up a SAR plan for
employees that will vest in three years and be cash settled.
The total number of shares in the plan is 900,000.
AC estimates three percent of the shares will be forfeited each year,
the fair value of the SAR in the grant date is $14.69 per share.
So, the fair value on the grant date is $12,824,370.
Even though that's a fair value in the grant date,
none of the requisite service has been performed yet,
so on the grant date,
nothing is vested, nothing is recorded.
So now, at the end of year one,
the fair value of the options has increased to $20,
so the liability is remeasured.
And the compensation expense attributable to the first year of the vesting period
will therefore be 900,000 times 97 percent times $20.
And then, we'll take it times one-third.
If it's a three year vesting period,
we'll have $5,820,000 of compensation expense.
Now, notice we are taking the fair value of the options,
and not the fair value of the shares because we're measuring
the value of the stock appreciation right itself.
But of course, the value of that stock appreciation right it's
going to be based upon the underlying,
which is the fair value of the shares themselves.
So, assume that as of December 31st,
Year 2, the fair value is now $25 per stock in appreciation right.
We've got an increase.
I'm going to remeasure that and the vested amount
is recognized as cumulative compensation expense.
So now, I still have that 900,000 times 97 percent times $25.
That's my fair value of the stock options
cumulatively still accounting for the three percent forfeitures in there.
And I'll take it times two-thirds because now two-thirds of
it's vested, which is $14,550,000.
I'll subtract the amount of previously recognized as comp expense,
and I'll recognize that increase as compensation expense for the current year.
Then journal entry is going to be then to recognize
$14,550,000 minus the $5,280,000 previously recognized.
So the increase in the fair value,
just like a fair value through net income model for a trading security,
the increase in fair value is
recognized as compensation expense and a corresponding liability.
And the cumulative liability now will be the $14,550,000.
And Year 3, well,
let's have a decline in the fair value.
The stock prices of course don't always go up.
You could have a fair value that declines to $20,
first stock appreciation right at the end of Year 3.
But the award is now fully vested,
so even though the fair value went down,
I'm still going to have an increase in the stock price,
in the compensation expense because I'm recognizing
compensation expense based upon now 100 percent of the fair value of the stock.
So, it's maybe a little hard to get your head around originally but what's happening is,
even though the stock price went down,
I'm still taking some of that fair value that was only two-thirds vested before,
now it's 100 percent vested.
I'm still going to have an increase in the value of the award
overall in terms of the compensation expense and my liability.
So now, with that award fully vested,
the fair value is going to be the 900,000 times 97 percent assuming
the three percent actually did forfeit times the $20 per share.
I'm going to have a new fair value of the award of $17,460,000.
Again, assuming the estimate of forfeitures was accurate,
and this will probably be the fair value of the stock on that date as
well because the fair value of the option and
the fair value of stock will be the same on that vesting date.
So now, the net expense for the third year
is going to be that compensation costs the total fair value of
$17,460,000 minus $14,550,000 is $2,910,000 compensation expense in that third year.
Again, the stock price went down but because the vesting went up,
I'm still recognizing additional compensation expense.
Now, if they held on to this SARs and did not exercise them,
any future decreases in stock prices would cause a reversal of compensation expense.
You would have a credit compensation expense for the decline in the stock price.
But here we're going to look at the exercise.
So, when the exercise at the end of the three years,
the employees take the money and run,
they want the $17,460,000.
The company pays out the cash in that liability that they've recognized
cumulatively for the SARs liability is relieved.
What if it's an equity-settled SARs?
Well, they're accounted for similar to stock options.
The grant date fair value is recognized over the vesting period.
The awards are not remeasured each reporting period.
So, they're going to be settled with shares.
So, I'm going to take that amount in equity.
And when I issued the shares,
I will reclassify the amount in equity for SARs to equity for shares,
and the difference is going to be accounted for as a pick,
a reduction in a pick in this case.
Then, close our discussion on stock appreciation rights,
there is similar to shares that's often used for
closely held companies that maybe don't actually want to issue stock
to its employees but do want to provide employees with the means of sharing in
the profits or to incentivize employees to work as if they are owners.
Sometimes, it's also used for other types of firms that again,
don't want to particularly issue stock to employees,
but they want to allow employees to
participate in the increase in the profits of the shares.
It's similar to a bonus plan.
It can be accounted for again as equity if
the stock appreciation rights are settled in stock.
However, if they are,
or can be settled in cash,
they're accounted for as liabilities. Thank you.
John HeppClinical Assistant Professor of Accountancy
