Hello, I'm professor Brian Bushee and welcome back. In this video we're going to take a look at stock-based compensation. So giving managers restricted stock or stock options as a form of compensation. Now this co, topic gets very complicated very quickly, and in fact I spend two classes on this in my advanced accounting elective. What we're going to do in this video is scratch the surface. Give you enough knowledge to know what's going on so that you can understand this disclose, these disclosures in the financial statements. Let's get started. We're going to talk about two different forms of stock-based compensation. The first is restricted stock plans. These are where companies play their employees with shares of stock as compensation. >> Do companies really pay employees with stock? Or do they just pay the fat cat, big wheel, overpaid, self-important, c-level top executives with stock? >> Actually it is the fat cat, big wheel, overpaid, self-important, c-level top executives that get almost all the options. There are some companies that have given options deeper into the organization to middle managers or even to hourly type employees, but for the most part the idea is that top management is the one making the decisions that's going to have the most impact on stock price. So to make sure that they make decisions that are aligned with shareholders interest, in other words make decisions to try to make stock price go up, we tend to load top management with the stock options. Anyway the other form of stock-based competition we're going to talk about are stock option plans. This is where companies grant employees the right to purchase a number of shares of stock at a fixed price, called either the exercise price or the strike price, over a specified period of time often up to 10 years as a form of compensation. Most the time the exercise price is set equal to the stock price at the time the options are granted. So if the stock price was $20 today the option would be granted with an exercise price of $20. This is called an at-the-money option. >> What the lamb are you talking about? How is giving employees the right to buy stock a form of compensation? It is like, here is your paycheck, now you owe me money. >> So these stock options are only compensation if the stock price goes up, if they don't go up, then they're, they're worthless. But if the stock price goes up then what the manager can do is buy the stock at the exercise price, which is going to be lower than the current price, then they resell it at the current price and make a profit. The different between the current price and this lower, exercise price. In some companies they've even cut out the stock transaction. They've gone to cashless options where they just give managers the difference between the current price and the exercise price when they want to exercise, but in any case, this is compensation. But it's compensation that only kicks in if the stock price goes up, but that's why we give this compensation, because we want the managers to do things to make the stock price go up. Generally for these two forms of stock-based compensation, there's some kind of vesting period, like one to three years, that has to pass before the employee is allowed to either sell the stock or exercise the option. So the idea here is that companies don't want to give you the stock or the option, the stock price goes up after three months, you, you know, cash out your option, you sell your stock and then you leave the company. So to get you to hang around and try to make the stock price increase over time, they make you wait two to three years before you can cash in on the stock-based compensation. The value of the restricted stock or the options that are granted is going to be treated as an expense and then recognized over this vested period. >> This doesn't make any sense. How can a stock option be an expense? The company is never giving the employee cash. There is no payable. This is a nonsense expense. >> So both the FASB and the IASB view stock options as a form of compensation, and just like we expense cash compensation, we should expense stock option compensation as a cost of generating revenue. So even though there is no direct cash outlay for the stock compensation, it's still something to give to, we give to employees to get them to work for us to generate revenue and so it should be cost of doing business and there needs to be an expense. Now, companies fought this for over 20 years. The Standards Centers first proposed making this expense in the mid 80s and it wasn't until the mid 2000s until this finally went through. In fact there was a big controversy in the mid 90s where companies would heavily donate money to politicians. There was a famous US Senator that actually introduced a bill which said that the, and I'm paraphrasing, that the senate would outlaw the FASB if the FASB went ahead with this rule to require stock options to be an expense, and as a result the FASB caved in and it was another 10 years before stock options were made an expense. So as I said, all of the legitimate and important concerns about this rule were cautiously deliberated over the two decades and everyone fully agreed that the correct thing to do by 2006 was to require that stock-based compensation would be an expense. Lets take a look at an example of how a restricted stock grant works. So on January 1st, 2013, Stack Incorporated grants 1,000 shares of stock to its CEO as a form of compensation. Stock price is $20 per share on the grant date. The stock will vest after two years. Which means the CEO can then sale the stock if he or she wants to after that two year period but not before then, and the par value is 50 cents per share. For the journal entry I, I'm not going to put up the pause sign. We're going to walk through this one together. We're going to debit something called deferred compensation expense. This is going to be another contra shareholders equity account which means that it goes up with a debit. Down with a credit. This is going to store up the compensation expense until we get a chance to expense it over the vesting period. The amount that we're going to put in here is 20,000. That's the 1,000 shares of stock times the $20 per share market price on the grant date. Since we're issuing stock, we're going to credit common stock for 500. That's the 1,000 shares times the 50 cent per share par value, and then we're going credit AIPAC additional credit paid in capitol for 19,500. That's the plug. >> Deferred expense? Contra shareholders equity? This doesn't make any sense! >> Of course, it makes no sense. There is par value involved. >> Yeah, the standard's editors had to do a little bit of a finesse here because the company is issuing new shares, but they're going to the employee and the employee can't do anything with them yet. The employee is not a full owner. They can't sell these shares like a regular stockholder. And so you've got this vesting period that we have to wait before the shares fully belong to the employee. Plus there's the question of matching the expense to the revenue it generates. So if the idea that the employee has to work for two years in order to get the stock then that cost of the stock should be spread over the two years over that two year vesting period. So this contra shareholders' equity deferred compensation expense stores up this expense until we can spread it out over the two years that the employee works for us thereby matching the expense to the revenue this person is presumably generating. Now let's take a look at what happens over the vesting period. So it's the same set up we've granted the restricted stock. Journal entries that we need to do to recognize the expense of the vesting period would be at the end of 2013, so 12/31/2013. We're going to debit compensation expense for 10,000 to recognize one year expense. We're going to credit the deferred compensation expense of 10,000 to basically take out that first year's of expense of from this deferred compensation expense account where we're storing up the expense until it moves on to the income statement. And then on 12/31/2014, we would do the same entry debit compensation expense, credit deferred compensation expense. So at this point, the stock is fully vested. It's also fully expensed. There's no more balance in the deferred compensation expense. Now one quick note, I assume that it was straight line, equal amount each year. There's other ways that you can do it. And just in general there's a lot of complexities involving the stock-based compensation accounting that we're just not going to get into in this course. So for now I just assume straight line. Which is a very common way to do it but not the only way that you could have to recognize the expense over time. >> What would happen if a stock price goes up over the two years? Shouldn't there be more compensation expense in that case? >> So in this case we ignore any movements in stock price after the grant date. So the idea is that the compensation we're giving the employee is the value of the stock on the grant date. After that it's just the employees good luck or bad luck if the stock price happens to go up or down. It doesn't change the value of what we initially granted the employee on the grant date. So we don't take account any changes in stock price in the company's expense. Any movements in stock price are good news or bad news for the employee but irrelevant for the expensing of the restricted stock by the company. Now let's take a look at the other common form of stock-based compensation, a stock option grant. So on January 1, 2013, Stock Incorporated grants 100 options to its CFO with an exercise price of $20 as a form of compensation. The options vest after two years and expire after 10 years. Which means that any time from year three to year ten the CFO can exercise the option to buy the stock at $20, the exercise price. The stock price is $20 on the grant date which means that it's, it's granted at the money. The fair value of the option is $18 per share at the grant date. That means that the fair value of the whole stock option grant is 1,800, so 100 options times $18 per share. This fair value will be amortized over the vesting period as an expense. >> What is the fair value of an option grant? And why is it less than the stock price? That is what we would call an unfair value back home in Wellington. >> Actually this fair value is not an unfair value. But it represents what an investor would pay for this option on the open market. So it is meant to be the correct or fair value of this option. Now the reason why the fair value is less than the current stock price is that the option only has value if the stock price goes up from $20. If the stock price stays at $20 or goes down the option is worthless. So part of what the fair value is estimating is the probability that the stock price will go above 20. If it goes above 20, then the stock option will be worth whatever the difference is between the current price and this $20, and if goes below 20, the stock option is worthless. The fair value estimate tries to take all that into account, and there's a lot of sophisticated techniques that we're not going to talk about to do this. The Black–Scholes model, the lattice binomial method. But for now just trust me that this fair value is indeed a fair value. So the journal entries here will be that on 12/31/2013, so at the end of year we're going to recognize compensation expense for the stock option grant. So we're going to debit compensation expense for 900. That's the 1,800 fair value divided by two. Because there's a two year vesting period. And we're going to credit additional paid in capitol for the 900. Now we don't want to treat this like restricted stock where we credit common and AIPAC because we're actually not issuing new shares of stock at this point. We're just recognizing an expense for this grant and so the standard setters decided to put the credit into APIC, not to do it in a common stock because we haven't actually issued any common stock. And we want to keep that balance in common stock equal to the par value times the number of shares issued. Then on 12/31/2014 we will again debit compensation expense and credit additional paid in capital so that at the end of the two years the vesting period expires. We have fully expensed the stock option and now the CFO is free to go ahead and exercise it down the road at any point. >> Why is there a credit to APIC? Why not just toss this credit into accumulated other comprehensive income? >> Yes, the journal entry should be debit nonsense expense and credit accumulated other comprehensive nonsense. >> Whoa. I sure hope that no one at the FASB ever sees these videos where you're calling this accumulated other comprehensive nonsense. I think they're quite proud of AOCI. It would not be appropriate to put this in AOCI because it is already running through the income statement. There is a compensation expense on the income statement. Remember AOCI is for things that we normally would put on the income statement but we don't want to so instead we put it in AOCI. So the question is why put it in APIC? I don't know where else to put it. It doesn't really fit in any other kind of account. It's sort of like we're issuing stock but not quite because we really haven't done it yet. So I think what happens is we just put in APIC because we need the balance sheet to balance and we're doing weird things with APIC anyway so why not go ahead and credit APIC in this transaction? Finally let's take a look at what happens when the stock option is exercised down the road. So on June 6th, 2018 the CFO exercises the 100 options to buy the stock at the $20 per share exercise price. The market price of Stack's stock is $30 per share on that day, and what Stack is going to do is reissue some treasury stock to sell the shares to the employee. So the treasury stock that we're going to reissue is acquired at $11 per share, which is relevant for the journal entry. So the journal entry is that we are going to debt cash for 2,000. The CFO is paying us, as Stack, cash to buy the stock. We get $2,000 which is 100 options times $20 exercise price per share. We're going to credit treasury stock at 1100. That's 100 shares of treasury stock that we're re-issuing, times the original price was acquired of $11 per share. To make this balance we plug our good friend APIC 900. We can't show a gain or loss in this because it's a transaction of our own stock, so we credit APIC for the difference. Now as it turned out the market price of $30 wasn't relevant for this journal entry, but it is relevant because Stack is going to get a tax deduction equal to the difference between the market price and the exercise price. So 30 minus 20 times 100 shares, which is $1000. So Stack can basically take that $1000 put it on their tax return as a deduction and reduce their taxable income. These tax savings are going to be considered a cash flow from financing activities. And the reason why Stack gets the, the, the tax savings is that this $1000 is the taxable income for the CFO. And so this really shows you how the stock option provides compensation for the CFO, because on state they're going to buy the stock from Stack at $20. Then they can immediately resell that stock on the market for $30. Making a profit of $10 per share. $10 per share times a 100 shares is a profit of 1000. That $1000 becomes taxable income for the CFO, so the CFO's going to get taxed on that, because it's taxable income for the CFO it becomes a tax deduction for Stack. Stack gets to save the money and that tax savings will go as a cash flow for financing. >> I do not even know where to begin with my questions on this slide. Maybe just explain the last part again. >> I actually thought I did a pretty good job explaining the last part of the slide, but okay let's try it one more time. So when an employee exercises a stock option they're able to buy the stock at 20, sell it at 30, they make a profit of $10 per share. That profit of $10 per share is considered taxable income. So it goes on the employee's tax return and they pay taxes based on it. Now the IRS in the US has this philosophy of reciprocal taxation. So what's taxable income for one party of the transaction is a tax deduction for the other party. So the firm, the company, gets a tax deduction equal to $10 a share. That tax deduction will help them save taxes and those tax savings, that cash that they get in tax savings, is considered a cash from financing. Now this can get more complicated very quickly because if these tax deductions due to option exercises are big enough they can actually call, cause the company to have a net operating loss for tax purposes. Which then would put us into the whole, valuation allowance, deferred tax asset, NOL carryforward stuff that we talked about last week. And in fact, I could probably spend another six hours just providing you more details about the stuff at the bottom of the last slide, but you know what? Look at the time. I think we all need to run along so I'm just going to stop here. I've given you sort of enough knowledge to be dangerous on stock options and it's time to move on. So a, a little confession here. I actually do not enjoy teaching stock-based compensation. And I think part of the reason is I've never had it myself. As someone that works for a university we don't get stock options we just get fixed salary. And in fact what I'm doing now is I'm doing things for free. So I'm really far from the stock option experience. But it is something that you see a lot in the real world and a lot in the financial statements. So hopefully this gives you a basic building block for understanding it, and we're going to see one of the ways where it affects other things in the financial statements when we talk about earnings per share in the next video. See you then. >> See you next video.
