SHARE BASED COMPENSATION

Question 1

What is the difference between stock options, restricted stock unitfs and performance shares?

Answer 1

Stock options are non trade able call options. Basically employee’s benefit if the share price goes above the current value.
Restricted stock units. These can be exchanged for shares upon settlement. They do not have voting rights or dividend rights during the vesting period
Performance shares. These are grants that only vest if specific targets are met (they can be linked to financial metrics)

Question 2

What is the value of the expense for Stock Based Compensation based on?

Answer 2

Based on the fair value at the grant date

Question 3

What is the balance sheet and income statement treatment of stock based compensation

Answer 3

On the income statement the value is amortised over the vesting period of the stock.
On the balance sheet, the expense will reduce retained earnings, and a corresponding increase occurs int he share based compensation reserve, this basically increases equity.

Question 4

What is the process for paying stock based compensation options when the share price increases?

Answer 4

Basically the company continually pays into the stock based compensation reserve, and this comes out of retained earnings. This ammount then stays fixed. Once the vesting period is over on the balance sheet, the company then issues new shares to the employees. This only affects existing shareholders. They pay for this through an increased number of shares and a smaller percentage of the earnings attributable to the common shareholders.

Question 5

What is the fair value of a stock option based off of

Answer 5

The comparable value of a comparable option, if a comparable option exists. If there isn’t a comparable value then they can use an option pricing model.

Question 6

What are all 6 of the inputs that any option pricing model requires you to input, and what element is the most subjective and sensitive. What is the exception to this rule

Answer 6

Exercise price
Life of the option (usually the vesting period)
Current price of the underlying shares
Expected volatility of the underlying shares (this is the element which is most susceptible to gaming and for the company to get wrong)
Expected dividends
Risk free interest rate

Exception to the rule is for private companies because estimating the value of the underlying company is the hardest part. Companies are allowed to estimate this value through an independent appraisal, usually with the last 12 months or another valuation method that must be defensible.

Question 7

What happens to the share based compensation reserve upon settlement. Where is cash received from employees for the strike price recorded

Answer 7

Upon exercise the value in the reserve is moved to common stock and paid in capital. The cash received from employees for the strike price is reported as a financing activity.

Question 8

What are the limitations with the BSM model for option pricing and what does it stand for

Answer 8

Black - scholes - Merton

Inappropriate for optiopons with long lives because you cannot account for early exercise.

Question 9

What is the full accounting process from start to finish of stock options.

Answer 9

Basically at the date of the option award you ammortise the fair value of the option until the vesting date. This reduces net income by a yearly charge, which reduces the retained earnings.
This ammount is funnelled into the share based compensation reserve.
No change to total equity
So the employee pays the value of the exercise price, then oyu add this to the share based compensation reserve, and record this as a financing activity.
Basically got two amounts that are going to be combined here, the first ammount is the fair value of the option and the second is the price that the employee pays as the strike price of the option.

Question 10

What it’s the measurement hierarchy for accounting for stock options?

Answer 10

1) market based evidence - you find the value of a similar option and price it off of that
2) valuation model
- BSM usually used by non public entities because it is the least complex
- lattice (binomial) models are more flexible because they can show the impact of early exercise on an option’s life.

Question 11

What is the impact on the financial statements of over or under estimating the volatility of stock options.

Answer 11

If you use a lower estimate of volatility you will underestimate the value of the options, this means that you underestimate the compensation expense, which will increase your retained earnings. Earnings ratios will be higher because you are effectively reducing a charge.

Question 12

What are conditional grants and stock grants what are the 3 main types

Answer 12

Conditional grants only vest if specific hurdles are met, there are 3 main types
Service conditions - most common requiring the employee to remain employed for a certain number of years
Performance conditions - require achievement of certain corporate targets like eps. Performance shares another name
Market conditions - usually related to the stock price reaching a specific value.

Restricted stock are shares which are granted upfront but have conditions on sale. Usually carry voting rights and can receive dividends.

Question 13

What is the difference between RSU’s and Restricted stock?

Answer 13

RSU’s do not carry voting rights during the vesting period and do not receive dividends. These are good because they have value regardless of the share price as long it is above 0 and don’t actually need to pay the exercise price for the shares.

Question 14

What is the fair value of restricted stock grants

Answer 14

Market price of the stock on that date.

Question 15

What is the fair value of RSU’s

Answer 15

Because the empoyee does not receive dividends during the vesting period, the value of the RSU is reduced by the estimated fair value of the dividends over that vesting period.

Question 16

What expense is recognised for RSU’s and restricted stock?

Answer 16

The annual compensation expense is calculated as the total fair value of the grant divided by the vesting period (amortised) this is done over the straight line of the holding period.

Question 17

What is the dilution treatment of RSU’s and unrestricted shares. What is the anti-dilutive threshold

Answer 17

Unrestricted shares and RSU’s are potentially dilutive. They are therefore included in diluted eps calculations using the treasury stock method.
When stocks are significantly out of the money, stock options are anti-dilutive. The logic for this is as follows, following the treasury stock method. Basically if you received 50 for an employee exercising the option they have, and your shares are trading at 25, you could buy back 2 shares to give to the employee who is only entitled to 1 share, so you would reduce your shares outstanding by 1 share, improving eps metrics.

Question 18

What is the treatment of anti dilutive securities is the company is loss making

Answer 18

If the company is loss making then adding ANY POTENTIAL SHARES to the denominator, would spread the loss over more shares making the loss look less bad. this would be ANTI DILUTIVE.

Question 19

Why are anti dilutive securities important

Answer 19

Anti dilutive securities are important because they might become dilutive in the future. Usually they are only anti dilutive because the share price has been low for a long time. This could always reverse.

Question 20

Where is stock based comp reported and what are the different approaches called?

Answer 20

Stock based comp is not reported typically as a separate line item, however it is imbedded within COGS, R+D and SG+A.
The proportionate approach is when the historical relationship between these expenses is expected to remain static, analysts often forecast total expenses as a simple percentage of revenue.
Separation approach is when you think that these proportions are likely to change. You separate these three out, then take stock based comp away, and then adjust the total charge separately.

Question 21

What cashflows is stock based comp added back to in order to arrive at the final value

Answer 21

CFO

Question 22

What Cashflows line does stock based compensation expense flow into when the shares are to be vested

Answer 22

CFI

Question 23

What are some of the common financial modelling techniques used to account for stock based compensation.

Answer 23

Analysts should forecast the increase number of shares outstanding to account for dilution.

Question 24

What is the impact of reporting higher stock based compensation as a percentage of total compensation on the financial statements

Answer 24

Because stock based comp is non cash, a company with higher non cash compensation, will report higher cash based metrics, including free cash flow. It would be misleading to use a P/FCF analysis for two companies without taking into account that one of them has a higher non cash compensation expense.

Question 25

What are the two types of post employment benefits

Answer 25

Pension plans Other post employment benefits

Question 26

What are some types of other post employment benifits

Answer 26

Heath care and medical insurance Life insurance Funding difference. - OPEB plans are not pre funded, so any funding the company pays for the benefits out of current cash flow.

Question 27

What is the definition of funded status

Answer 27

Funded status is the difference between the plan’s assets and the benefit obligation. the benefit obligation is the present value of what is owed. If assets exceed obligation then the plan is overfunded, if obligations exceed assets the plan is underfunded.

Question 28

What is the definition of service costs as it relates to pension plans. What are re measurements

Answer 28

Represents the increase in the benefit obligation resulting from employee’s working one more period and earning more of their future retirement. Re measurements are actuarial gains and losses that arise when assumptions such as retiree mortality rates change over time.

Question 29

How are defined continuation pension plans accounted for

Answer 29

Defined contribution pension plans are accounted for by recognising a pension expense equal to the employers contribution with noting reported on the balance sheet. The expense flows only through the income statement on defined contribution plans.

Question 30

What are primary health care benefits for retired employees

Answer 30

Primary healthcare benefits for retired employees are where the employer will pay for healthcare benefits for the whole of the retirement period.

Question 31

What is the meaning of overfunding and underfunding

Answer 31

Overfunding is when the retirement pla assets exceed the pension obligation, underfunding is when the plan assets are not enough to cover the pension obligation. This basically relates to whether there is enough money in the pension pot to pay the obligations or not.

Question 32

What is the balance sheet treatment of future pension benifits What do you have to assume about the company in order to calculate a PBO

Answer 32

The projected benefit obligation PBO is the actuarial present value of all future pension benefits earned to date. Based on expected future salary increases

Question 33

How do you calculate a PBO what are some actuarial assumptions

Answer 33

To calculate a PBO you firstly assume that the firm is a going concern because you have to project what a likely final salary is going to be at retirement. You have to calculate the present value of the value that they are going to pay out to the people on the pension. You use a discount rate which is related to the yield ON HIGH QUALITY investment grade corporate bonds. This depends on a set of assumptions on mortality rate, retirement ages, and employee turnover.

Question 34

What are some factors that are likely to increase the PBO and what are some factors that are likely to reduce the PBO

Answer 34

Increase in the current service cost, meaning that people have worked one more year so earned more unit of retirement benefit Interest cost. Given the PBO is the present value when you discount by one less year you get a higher value If you increase the past service cost, so increase th percentage that you get for each year of service, then you increase the PBO immediately Actuarial gains and losses, when you lower the discount rate, or assume employees will live longer. Paying benifits when you actually pay out of the plan, the total plan obligation is reduced.

Question 35

When do you report a net pension liability and when do you report a net pension asset Explain what this means. Is this the same under us gaap and IFRS

Answer 35

Net pension liabilities are when the PBO is greater than the plan assets Net pension assets are when the PBO is less than the plan assets Given the PBO is basically the amount that you owe, the fair value of the plan’s assets is basically compared to this value. If you have more than you need, it’s an asset. If oyu have less it’s a liability. YES

Question 36

What is the income statement treatment of post employment benefits (pensions) for defined contribution pension plans

Answer 36

For defined contribution pension plans the pension expense is simply equal to the employers contribution for the period.

Question 37

What is the income statement treatment of defined benefit pension plans under IFRS

Answer 37

IFRS focuses on a net approach. Each plan must be reported separately in the BLANCE SHEET (important but doesn’t relate to the income statement) Income statement The service cost relates to the CURRENT BENEFITS payed today. This is split into two sections under IFRS. The current service costs are the value of the benifits that have been earned that year (for example 2% times by the year times by the salary) then the past service costs is when the plan changes, for ALL YEARS including those that have already been worked. For example by increasing the percentage increase that you get for each year worked. This would be a past service cost. Usually they are both grouped on the income statement through and are not split out Net interest expense/income: this comes from the pension liability/assett times by the discount rate. A massive assumption here is that the pension asset or liability is only gaining interest rate at the same rate as the discount rate rather than earning interest at a higher rate than that. OTEHR COMPREHENSIVE INCOME Re measurements including actuarial gains and losses and the difference between the actual rate of interest earned and the rate of interest assumed in the net interest expense. These all go through OCI and are never amortized into the income statement in future periods.

Question 38

What is the treatment of defined benefit pension plans under US GAAP

Answer 38

Balance sheet is the same as IFRS Income statement the current service cost is recognised in the P and L as an operating expense. However the interest cost is calculated on a gross basis. This means that the calculation is the (Beginning PBO x Discount rate) basically the income statement the interest cost is equal to the ammount that the PBO increases each year by reducing the discount rate by one year. This is the same as multiplying the PBO by the interest rate. Management then use an expected return on assets which is the long term rate of return. This is then mulitiplied by the plan assts, which is then used to offset the reported pension expense in the PNL. The equation is then basically, what should the pension have returned this year based on our predicted rate of return, what is the increase in value of the pension that occurs from a reduction in one period of the discount rate (this is what the PBO on a gross basis means) and then what is the value of the obligation that employees have worked by working that year If oyu think of it as A B and C it’s B+C-A is the value of the EXPENSE.

Question 39

What proportion of acturarial gains and losses are you allowed to amortize over time under IFRS and US GAAP

Answer 39

You are not allowed to amortise any of the income that comes through OCI back to the PNL under IFRS

Question 40

What is the accounting treatment of the difference between the expected return of the pension plan and the actual return of the pension plan under USGAAP

Answer 40

Under us gaap any differences between these two values are addressed in the OCI account. This is used to balance out the difference.

Question 41

What is the meaning of the corridor approach and when is it used what is the amortisation period What is the treatment of amortising an acturarial gain What about a loss

Answer 41

The corridor approach basically means that you only have a proportion of them recognised in the PNL once they reach a certain size. It is 10% of the greater of the BEGINNING projected benifit obligation PBO Or the beginning fair value of plan assets You only amortize when the beginning balance of accumulated actuarial gains and losses exceeds the 10% threshold. Only the piece outside the corridor is amortised onto the PNL The amortisation period is spread over the expected remaining service life of the employees in the plan. When amortising an acturarial gain it’s a good thing for the firm. This means that it reduces the expense on the PNL and basically acts as credit When amortising an acturarial loss it’s a negative thing for the firm. This means that it increases the expenses on the PNL and it acts as a debt. Assumptions that the actuaries made about the life of the pension fund are essentially inaccurate and you have to pay more than you initially thought.

Question 42

What is the cash flow impact

Answer 42

The benifits payed out to retirees do not actually impact the company cash flow. However the contribution to the plan assets is reported as CFO.

Question 43

What are some examples of aggressive accounting when it comes to pensions and what is the impact on the financial statements How are reported results affected by management assumptions

Answer 43

A high discount rate will reduce the present value of the liability. Low salary growth and low life expectancy also reduces the value of the liabilities. If you expenditures a high rate of return on future assets for US GAAP you can be expected to reduce the reported pension expense and increase net income. This is hte case even if your actual market performance is bad. Comparability different firms may use different rates, which oyu have to be able to interpret. Non gaap measures, some firms may strip out certain amortisation costs of acturarial gains and losses. And earnings quality as certain adjustments can mask poor quality earnings.

Question 44

What is the definition of a grant

Answer 44

When an employer states what you are going to get, you haven’t received it yet

Question 45

What is the definition of vesting

Answer 45

When the employee has EARNED but not received the comp

Question 46

What is the definition of settlement

Answer 46

When the employee actiually gets paid the comp

Question 47

What is the treatment of IS 19

Answer 47

When you recognise comp at fair value and it vests as you earn it Libailities arise for short term benifits, then you pay it liability and cash down

Question 48

What is IFRS 2 used for

Answer 48

Used specifically for share based compensation

Question 49

What stock price is used for share based compensation

Answer 49

The stock price at grant date

Question 50

Where does the share based compensation reserve sit

Answer 50

Wishin equity

Question 51

What happens when you issue share based compensation What offsets it when it’s paid out

Answer 51

You pay out of the share based compensation reserve, and it’s replaced with the share capital and the additional paid in capital, which will summ up to the ammount of the stock based compensation reserve.

Question 52

What are stock aappreciation rights

Answer 52

They are basically options on stock that are paid out in cash

Question 53

What is restricted stock called if it’s based on service and performance

Answer 53

Performance shares

Question 54

Is restricted stock tradable

Answer 54

No

Question 55

Do you have voting and dividend rights remain on restricted stock

Answer 55

Yes it does, you still own the rights to the stock and you might still get paid the dividend you just can’t sell the stock.

Question 56

What are restricted stock units

Answer 56

Basically a certificate that represents stock, basically they cut the vote and the dividend from you.

Question 57

What is the compensation expense for restricted stock and rsu’s at the grant date Are they the same

Answer 57

It is the fair value of the underlying shares at the grant date No becuase the restricted stock unit has a lower value because the dividend isn’t paid

Question 58

What is the accounting treatment of stock options

Answer 58

You have two fair value the option at the grant so you have to look at the options available in the market. And you have to try and find ones that reflect the charecteristics of the options that you have. Have to expense the fair value of the option over the 5 years. Evenly spread out.

Question 59

Does a lower dividend yield lead to a higher or lower option price

Answer 59

It would be a higher option price because the opportunity cost of having the option is lower

Question 60

Why do companies now prefer to issue restricted stock units rather than stock options

Answer 60

Because you used to expense options based on intrinsic value which used to be 0 becuase you were issuing stock at the strike price. So there was no expense Now you have to expense the fair value of the option rather than the intrinsic value

Question 61

What is the different between the financial reporting and the tax reporting for stock based comp

Answer 61

The financial reporting expenses over the vesting period, however the tax treatment is done at settlement. And the tax is done at the share price at settlement. It’s an expense for TAX purposes, which is deductible as a tax expense.

Question 62

What happens to your compensation expense on the income statement versus for tax purposes What is the difference between the effective tax rate under IFRS and US GAAP

Answer 62

You have a higher tax expense, which l;eases to a lower taxable income, which leads to lower taxes paid. Your taxes paid, then is lower than your tax expense which means you need to recognise a 20 gain in equity (under IFRS). As a tax windfall. However under US GAAP you just reduce the tax expense equal to taxes paid. An implication is that the effective tax rate will look different between IFRS and us gaap

Question 63

Diluted earnings per share

Answer 63

Basically you take the strike times by the number of options then you work out how many shares would buy back that stock and that’s your diluted share price. You only have to do this if the options are in the money

Question 64

What happens to basic eps when you have restricted shock units

Answer 64

Nothing

Question 65

What happens to diluted eps with restricted stock units

Answer 65

Basically you treat it as paying for a cash expense upfront with something that is not cash. Therefore you save the cash proceeds which is the value of the restricted stock units Then you are able to buy back the stock that you have just given away with the cash proceeds that you have saved by compensating in stock Then you buy back as many shares as possible using the cash proceeds that you have saved and then reduce the shares that oyu have issued with the ones that you have just issued

Question 66

Can you increase EPS in dilutive eps

Answer 66

No

Question 67

What happens when you are in a loss, and you have an increase in the number of shares, is it dulutive or accretive

Answer 67

It’s accretive, and your eps goes up so therefore you have to ignore it and say that the earnings per share stays the same as the last period

Question 68

What is a trust

Answer 68

A trust is owned by the board of trustees so that the company cannot touch the pension funds

Question 69

What is the movement of the expense on the income statement when oyu work one more year under a direct benifit pension scheme What is a past service cost What is an interest cost

Answer 69

Expensed pension iobligation going up is called the current service cost, basically it’s a liability that grows through an expense on the income statement. Past service cost is when you have a plan amendment. If you make the plan less generous This is a negative expense so it’s added back to the income statement. Interest cost is the value that increases just becuase you get closer to the point when you have to pay someone. This is not the same as current service cost